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When you’re starting the process of buying a home, one of the most important decisions you’ll make is your mortgage selection. You’ll need to select the right one for your situation to ensure that you pay as little interest and fees as possible. However, this may be difficult if you’re new to the United States and purchasing a home for the first time, or even if you’re still building up your credit score. This guide to financing strategies will help you navigate the next step in your experience of buying a home.
This article discusses how debt can be appropriately used, and how it is analyzed.
Different types of mortgage debt are also discussed, such as a fixed-rate mortgage, adjustable-rate mortgage, federal housing administration mortgage, Veterans administration mortgage, interest-only mortgage, reverse mortgage, and home equity loans. The article also discusses the difference between renting or owning a home, and the costs associated with each one.
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Debt Principles to Consider
When deciding if you should pursue buying a home utilizing a mortgage, there are a few factors that you should consider. For one, taking on debt is only appropriate when it is matched with the economic life of the asset and the ability to repay. As an example, the purchase of a car that is expected to be used for 5 years/60 months has a maximum realistic economic life of 7 years/84 months.
Therefore, the car should be financed over 36 months but certainly not longer than 60 months. In other words, if you can’t afford to make the monthly payments within a reasonable timeframe, the amount of interest you pay along with the usable life of the item, will not be worth it.
Debt should be measured by the cost to take on the debt (acquisition fee, interest rate, prepayment penalties), and the estimated useful life of the asset. You should not take on debt to fund a lifestyle that you cannot afford.
If you have a high consumer debt balance, you should implement a debt management program into your financial plan. When paying off debt, you should generally give priority to those debts that have the highest interest rate first.
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Types of Home Mortgage for Buying a Home
There are several mortgage options for you to choose from. Review the ones listed below to find the best home mortgage for your situation.
A fixed-rate mortgage provides the same interest rate for the duration of the loan. It has a fixed payment amortization schedule. As the term of the mortgage decreases, the monthly payment will increase given the fixed interest rate.
Adjustable-Rate Mortgage (ARM)
This type of mortgage has fluctuating interest rates. Usually, in relation to an index, monthly payments will go up and down accordingly. Therefore, interest rates and payments may change from month to month. However, interest rate caps place a limit on how much the interest rate can change. Negative amortization occurs when the monthly payments are not sufficient to cover the interest due on the mortgage. The unpaid interest is then added to the principal.
Federal Housing Administration (FHA)
This mortgage type is guaranteed by the federal government. It has a low down payment, and sometimes even lower interest rates because of the federal government’s guarantee of repayment.
However, it has a mortgage insurance requirement.
Mortgage insurance is a policy that protects lenders against losses that result from defaults on home mortgages.
FHA requires borrowers to include mortgage insurance, primarily for borrowers making a down payment of less than 20%.
Veterans Administration (VA)
This type of mortgage financing is only for veterans of the U.S. Armed Services. There is no down payment or mortgage insurance required. It includes the same federal guarantee of repayment as FHA loans.
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This mortgage is where only the interest is paid monthly for a specific timeframe (typically 5-10 years). It benefits borrows because it keeps their mortgage payment to a minimum, but the principal balance will remain unchanged. Homeowners with a short time horizon for ownership and more liquid assets may favor this type of loan. However, if housing prices fall, the home may not be worth as much as the mortgage balance (making it difficult to refinance).
The terms of this mortgage type state that the lender pays the homeowner an income stream secured by the home. Payment amounts are based on the fair market value of the home and the age of the borrower. Borrowers must be 62 or older with a home that is free from debt to receive payments. Additionally, the homeowner retains the title of the home but incurs an increasing amount of debt each time a payment is received. If the homeowner dies, repayment of the outstanding mortgage is required.
Home Equity Loans/Lines Of Credit (Second Mortgage)
This financing option is essentially a second mortgage using the current equity in the residence. In a home equity loan, the borrower receives the money in a lump sum. In a home equity line of credit (HELOC), the borrower is only given a certain amount of credit to borrow.
The debt can be used for any purpose, and it won't affect the deductibility for tax purposes. The qualifying debt may be deducted for the lesser of:
$100,000 married filing jointly or single filer ($50,000 if the taxpayer files married filing separately)
The fair market value of the primary residence reduced by the amount of current indebtedness
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Mortgage Selection Issues
When choosing a mortgage, the main issue is the length of ownership. An ARM may be best fitted for a short length of ownership because the initial rate is typically less than a fixed-rate mortgage. However, rates on the ARM reset annually and could increase more in the long run.
You should also take into account your disposable income and risk tolerance to decide whether or not you should select a fixed or variable payment. However, if you do not have a high credit score, you may have no choice but to take the ARM because it's the only loan you qualify for.
You may be able to get a lower interest rate if you pay “points,” which is a payment to the lender that is made at settlement. When comparing a 15-year to a 30-year fixed-rate mortgage, the interest rates will typically differ 0.5% assuming the same down payment
Savings Due to Mortgage Selection
Compared to a 30-year mortgage, a 15-year mortgage will take less time to pay off and will have a lower interest rate. As a result, if you have a 30-year mortgage and no prepayment penalties exist, you will save thousands of dollars if you pay the 30-year loan according to a 15-year amortization schedule.
Mortgage payments consist of four main components:
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Buying vs. Renting a Home
When starting your house hunting, make sure that it actually makes sense for you to buy a home. Here are a few ways to tell if you should pursue buying a home or continue renting.
Purchasing a Home
When purchasing a home, mortgage payments are inevitable (unless you pay in cash), and fees such as down payment, closing costs, mortgage insurance, property insurance and taxes, maintenance, and operating expenses will be due too. Purchasing a home requires heavy upfront charges. However, mortgage interest, property taxes, and possibly mortgage insurance are tax-deductible expenses. Different types of mortgage payments can affect your cash flow in the long-term and short-term.
Renting a Home
You should consider the costs when deciding if renting a home or buying a home is right for you. When renting a home, the cost is fixed in the short-term, and there is no long-term commitment. There is also no property tax to be paid. Maintenance and repair costs are usually included in the rent. The cost of renters insurance is usually lower than that of owning a home. However, you’ll need to consider saving to purchase a home in the long-term.
Renting a home is beneficial if you are looking to stay in the same house for the short-term. But, if you are looking to settle for a long period of time, purchasing a home is more likely to be advantageous. The two major advantages of purchasing a home are tax deductions and home equity.
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Pick a Suitable Financing Strategy for Buying a Home
The first thing you should consider when selecting a suitable financing strategy for buying a home is if you even need to buy a home in the first place. It may not be the right time for you, especially if you’re only looking to live somewhere for a short period of time. However, if you want to settle down, then consider the mortgage types above to ensure that you get the best payment options and interest rate possible.
Overall, what you are approved for will depend on your credit score and the current interest-rate conditions. Make sure that you reach out to a professional if you need assistance determining what will be the best option. Even though in many cases mortgage debt is unavoidable, you can still select a good fit for furthering your financial goals.