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FIXED-RATE MORTGAGES

Fixed-rate mortgages are loans with set monthly payments that never change: they're fixed. Buying and selling these loans won't change their nature. Once fixed, always fixed.

Fixed-rate terms can vary in length as determined by the lender and selected by the borrower. Typically, the loans are issued in 5-year increments, beginning with a 10-year term. This 10-year period, during which the loan must be paid in full, is called the amortization period. Amortization periods are usually 30 years. That's what is meant by a “30-year fixed-rate mortgage.” The interest rate never changes and the amortization period lasts for 30 years.

Perhaps the next most popular period is the 15-year loan. Other amortization periods are 10, 20, 25, and 40 years—and sometimes you'll find a lender issuing a 50-year loan.

Why the different periods? To some extent, to make it appear as though the consumer has a choice. It's the same fixed-rate loan; just the payback period is altered. The question is, which amortization period is right for you?

I don't believe there is a “best” payback period. In general, go with whatever feels comfortable to you, doesn't crimp your budget, and offers the lowest possible interest rate. The shorter the term, the less interest you will pay. At the same time, a short term means bigger monthly payments. When you begin to review loan offerings, you'll see 30-year and 15-year rates advertised. Be sure to take a close look at what those payments will be.

Let's look at the payments for 30-year and 15-year loans on the same $250,000.

Term

Rate

Payment

30 year

6.50%

$1,580

15 year

6.25%

$2,143

The 30-year payment is $563 lower than the 15-year rate. So why doesn't everyone take the 30-year loan? After all, the payment is lower. Because when a loan is paid back over a shorter period of time, the interest rate is slightly lower (a 15-year fixed rate is normally about 1/4 percent lower than its 30-year cousin). Let's look at the amount of mortgage interest paid over the life of the loan.

Term

Rate

Payment

Lifetime Interest

30 year

6.50%

$1,580

$318,000

15 year

6.25%

$2,143

$135,740

That's $182,260 out of your pocket. Okay, not exactly, because mortgage interest may be tax deductible. But it's an expense and an extended cost to borrowing money.

Another reason to compare amortization periods is to see if you'll qualify for the loan. Lenders rely on something called debt ratio (discussed later in this chapter) to determine whether you're eligible for a mortgage. Your debt ratio is simply the amount of your loan payment—including taxes and HOA fees—divided by your gross income. Let's take that same $250,000 loan and add some additional items to calculate debt ratio.

30 year Payment

$1,580

Taxes

$ 200

HOA

$ 200

Total

$1,980

A common debt ratio for housing expenses is around 30 percent. So, in this instance a lender would say that your monthly income would need to be around $6,600 to qualify for the loan.

Now examine the 15-year loan.

The qualifying income for the 15-year loan would be $8,476, or $1,876 more than the 30-year loan. That's a lot of money! And thafs why people tend to choose the 30-year over the 15-year loan. The payment is not only lower, but it helps them qualify for the loan, too.

Paying less interest over the life of the loan is a good idea, but some buyers fear the 15-year payment schedule is out of reach. There are two alternatives: different amortization periods and prepayments.

 
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