The following is a guest post by Betsy Falwell, a good followup after last week’s post 6 financial must do’s for first time home buyer.
“…and it will only cost us $750 a month!” exclaimed the too-loud woman in front of me at Starbucks. We were both waiting for our beverages – me a non-fat, no-water chai tea latte; her some frothy type of seasonal drink – and it was impossible for me not to overhear the conversation she was having about her new home loan with the person on the other end of her cell phone.
I’ve been there. When I was a first home buyer, I was so excited about getting into a house of my very own that I wanted to shout it from the rooftops, if not in line at Starbucks. But I couldn’t help but wonder whether the gregarious woman had done all her homework while shopping for that home loan.
Not All Home Loans Are Created Equal
Home loans come in a variety of shapes and sizes – and, maybe most importantly to a first home buyer – interest rates. Here’s a basic breakdown:
- Fixed-rate home loans: When you sign on for a fixed-rate mortgage, you’re securing an interest rate for the life of the loan. Whether the market surges or crumbles, your rate is secure – as are your monthly payments. The main variation here is the length of the term. While you’ll find fixed-rate loans with terms as long as 40 years or as short as 10 years, in general, the longer the term, the higher the interest rate.
- Adjustable-rate mortgages: Usually called an “ARM” for short, this type of loan promises one interest rate for the first several years of your loan; after that introductory period, the interest rate can fluctuate depending on market conditions. Again, the term is a big deal; a 3/1 ARM means the introductory period lasts three years, while a 10/1 ARM’s intro period is a decade. The shorter the introductory period, in general, the lower the interest rate during that time.
- Interest-only loans: This loan keeps costs low by allowing you only to pay interest on your loan for a set period of time, while the principle balance remains unchanged. After an introductory period – usually between five and ten years – you’ll have to start paying down that balance, though. The result is lower payments up front, and far higher payments later on.
Calculating Your Income
Think your income is the amount of money your employer deposits in your account every other Friday? Think again. When it comes to calculating your income for mortgage purposes, lenders actually give your bottom line a boost. What lenders want to know when it comes to asking “how much can I borrow?” is your gross monthly income; that’s your income before taxes, medical insurance premiums, or 401(k) contributions.
If you’re a traditional employee who receives a W-2, you’ll find this information in Box 3 of your W-2. If you’re self-employed or receive a 1099 form, calculating your gross income is a little more complicated. In this case, your lender may give you credit for more than the income stated on your 1099 if you claimed work-related deductions on your tax returns.
A Lot Depends On Your Down Payment
Of course, the type of home loan you choose and the all-important term isn’t the only major factor for first home buyers. Your down payment will also play a big role in your monthly mortgage payments.
Back in the days before the housing crisis, lenders peddled zero-money down loans without any type of income verification, putting borrowers at risk of default. Well, we all know what happened next. These days, most banks want to see you put down at least 20 percent on a property; if you don’t, you’ll face private mortgage insurance, which can add several hundred dollars a month to your payments.
Is The Cheapest Loan Always The Best?
In a word, no. Let’s consider a 30-year fixed-rate home loan, a 5/1 ARM, and an interest-only loan with a 10-year introductory period. You can use mortgage calculators to compare the options for your specific financial situation, but in general:
- The 30-year fixed-rate mortgage will give you the highest monthly payments for the first five years, compared to the other two options.
- The 5/1 ARM will have the second highest monthly payments; after those five years, though, your costs could go higher or lower – it’s a borrower’s gamble.
- The interest-only loan will have the lowest payments for that first decade. After that, though, the principle balance is amortized for the remaining time left on the term. At this point, your payments will likely be far higher than the 30-year fixed.
Overall, the 30-year fixed may not get you the lowest monthly costs, but it will get you stable, predictable payments over the long run. That’s why this is one of the most popular home loans out there.