Editor’s note: This is the first of a two-part series.
In many, if not most, countries, borrowers are offered one type of mortgage: Take it or leave it. Borrowers in the U.S., however, can choose from a large menu of mortgage types designed to meet different borrower and lender needs.
These include fixed-rate mortgages (FRMs) with terms ranging from 10 to 40 years, and adjustable-rate mortgages (ARMs) with 30-year terms but initial rate periods ranging from one to 10 years. Many of these mortgages have an interest-only payment option for the first five or 10 years. And all are offered with multiple combinations of interest rate and lender fees.
Difficulties in making decisions
But having options is as much a curse as a blessing to borrowers who have no idea of how to make a selection. Most focus on the immediate financial burdens imposed by the mortgage, and give little thought to the future.
The loan originators (LOs) who borrowers encounter in the process are seldom helpful because their time horizon is even shorter than the borrower’s.
They want the loan to close so that they will get paid, and they fear that extended discussions of different loan types and options will slow down the process, and perhaps derail it altogether.
Their impulse is to suggest the loan type that the borrower might find acceptable, which may or may not be the best. Many LOs are not qualified to counsel borrowers effectively, even if they wanted to do so.
Using calculators to maximize future wealth
Borrowers should aim to be as wealthy as possible when their mortgage is paid off. To meet that objective, and subject to the constraints discussed below, a borrower should select the mortgage that has the lowest net cost over the period he or she expects to have the mortgage.
This approach is used in two new integrated calculators on my website. One enables the user to find the lowest-cost type of mortgage, while the second finds the lowest-cost combination of interest rate and lender fees on the selected type of mortgage.
These calculators are integrated in the sense that they use live market-price data provided by participating lenders, and the prices have been personalized to the characteristics of the user.
Selecting the best type of mortgage
The selection process is illustrated by the table below, which compares the total net cost of an FRM and an ARM. The comparison is made over five years using a tax rate of 25 percent and an investment rate of 2 percent. These assumptions are all specified by the borrower.
Total Net Cost: Two $270,000 Loans on Dec. 8, 2011
|
|
30-Year FRM |
5/1 ARM |
|
Interest Rate Closest to Zero Fees |
3.875% |
2.75% |
|
Monthly Payment |
$1,250 |
$1,102 |
|
Total Cost Over 6 Years |
$40,615 |
$30,416 |
|
Paid in Cash Upfront |
|
|
|
Points |
-$559 |
$667 |
|
Fixed-Dollar Loan Fees |
$1,300 |
$1,309 |
|
Payments |
$76,178 |
$66,135 |
|
Lost Interest at 2% |
|
|
|
On Upfront Costs |
$58 |
$154 |
|
On Monthly Costs |
$2,878 |
$2,499 |
|
Less Tax Savings at 25% |
|
|
|
On Points |
$0 |
$180 |
|
On Interest |
$12,952 |
$9,107 |
|
Less Reduction in Loan Balance |
$26,288 |
$31,061 |
|
|
|
|
|
Equals Total Costs Net of Benefits |
$40,615 |
$30,416 |
|
|
|
|
|
Worst-Case Interest Rate/Month Reached |
3.875% (1) |
7.75% (61) |
|
Worst-Case Payment/Month Reached |
$1,270 (1) |
$1,805 (61) |
Costs consist of cash paid upfront, monthly payments, and the interest loss on both at the interest rate the borrower can earn. Tax savings at the borrower’s tax rate, and the balance reduction over the period, are benefits that are subtracted from costs to measure costs net of benefits.
Budgetary and risk constraints
The borrower’s decision is subject to two possible constraints. Selection of the FRM is subject to the proviso that the initial monthly payment fits the borrower’s current budget. Selection of the ARM with its lower initial payment is subject to the proviso that the borrower is comfortable with the risk of possible future rate and payment increases.
The calculator quantifies the risk by showing the worst that can happen to the rate and payment, and the earliest it can happen.
The borrower must make the final decision. The table defines the choices, which are not limited to the two shown. The borrower in this case might want to look at a 7/1 ARM, which has a slightly higher initial interest rate than the 5/1 but two more years of rate protection.
The borrower can also calculate costs over different periods to see how it affects the results — few borrowers know exactly how long they will have their mortgage.
Next week: selecting the best combination of interest rate and lender fees.
