Debt Free

I've posted more than once about mortgages. Fitting, as mortgages are normally your single largest debt and the one many folks never get away from. That's not as bad as it sounds, as mortgage interest tends to be relatively low and have tax benefits not associated with most other forms of consumer debt. It may seem in many of the other mortgage related posts that I'm a huge proponent of the traditional 15 or 30 year fixed mortgage, and I've eschewed other mortgage products (of which there seem to be more every day). That's not really true. Mortgages are like anything else. Different products are a better fit for different situations.

Here are some examples of which mortgage products would fit some common financial and lifestyle scenarios.

1 – Traditional 15 or 30 year fixed mortgage – You plan on living in the home a long time, and have a stable income. You'll get a better interest rate by going with a 15 year mortgage, which will cost you more each month, but save you money in total interest over the life of the mortgage. You'll save money not only because of the lower interest rate, but because you'll only be paying interest for half the time. You can also select the longer term, which will give you the ability to have a lower monthly payment, but pay extra on the mortgage when your finances allow.

Be careful that you have a mortgage with no prepayment penalty. A prepayment penalty will severely penalize you for paying the loan off early. Some mortgages with a prepayment will offer a lower interest rate, but you should be extremely wary of a mortgage with such a clause. Your flexibility will be compromised, and it could ultimately end up costing you much more than you'll ever save in interest payments. You have other options when you select the 30 year mortgage. Some experts recommend using the extra cash for investments, because typically a mortgage is some of the cheapest money you'll ever be able to obtain.

2 – Adjustable rate mortgage – As the name suggests, an adjustable rate mortgage will have a variable rate, normally with a lower rate early in the loan. These have gotten more than a few people into financial trouble as the rate, and subsequently the payment, adjusts upward. An ARM can actually be a good fit for some, however.

Here are some situations where an ARM may be the best choice: You're only staying in the home for a short period of time. Say you take a 4 year job assignment. In that case, a 5/1 ARM would be a good fit. You'll benefit from a lower interest rate, and you'll be selling the home before the mortgage adjusts upward.

Another scenario where an ARM may be the way to go would be a situation where your income will be increasing in a relatively short time. Again, you can take advantage of the lower interest rate offered by the ARM when your income is low. Before the mortgage adjusts, you can either refinance to a conventional fixed mortgage product, refinance to another ARM if the rates are favorable, or just accept the higher, adjusted rate. You higher income will allow you the luxury of doing so without feeling too much of a pinch.

Where people tend to get into trouble with ARMs is when they can only get into a home by using the lower interest payment offered by the ARM. They think “Oh well, I've got to buy a house, and I can't afford it any other way. I'll figure out how to deal with the higher payment when the time comes, or I'll refinance.” The problem is that many people's income does not increase as they'd planned, they have additional expenses, such as children, or they underestimate how much the additional payment amount will impact their finances. That's how so many get into a bit of financial difficulty with ARMs. If the real estate market has done well in your area, you can sell the home and realize a substantial profit. In fact many people do just that. They can use the profit as a down payment on their next home. If, however, the market has stayed relatively flat or declined, you may be sitting in a property you can't sell for what you owe. You are, as they say, upside down.

3 – Interest only mortgage – Much of the same applies to interest only mortgages as does to ARMs. The biggest downside to interest only mortgages is negative amortization. In the beginning, you're not paying any of the principal, so you pay your mortgage for years and owe just as much as when you started. At the end of the interest only period, the mortgage will switch to a conventional, fixed mortgage and amortize the loan balance over the remaining term. Obviously, the mortgage payment will increase when this happens.

The rationale for choosing this type of mortgage is that with a conventional, fixed mortgage you really don't pay very much of the principal for the first 5 or 10 years anyway. Why not save some money, use it for other things, such as investment or financing a business, and refinance when the property values have shown a substantial increase. You can then use the equity in the property to secure a different mortgage. As with an ARM, an interest only mortgage is also a great fit for someone who'll be keeping the home for a relatively short period.

In many markets, the property values are so high that many buyers can only afford a home by using interest only mortgage products. In effect, they're renting their home from the bank, but are actually accruing equity at the same time (You'd better hope). Some buyers, in markets such as south Florida, Nevada and California, where home prices have reached the stupid level can find themselves in trouble. If property values experience a correction, you may be unable to refinance. You could find yourself owing hundreds of thousands more than your home is now worth. Those are, however the markets where these types of mortgages are the most popular, due to the extremely high home prices.

What home buyers should not do, in most cases, is use variable rate and interest only mortgages to buy a nicer, larger home than they can otherwise afford. Many use this technique so they can live in that nice, gated community, get slab granite counter tops, crown molding, 3-car garage, and a slick home theater system. Evaluate the pros and cons of your decision very carefully before you potentially put yourself in a position of house poverty. It can be hard to have to put your beloved home on the market because you can't afford to keep it, especially when you can't afford to sell it either.