Fixed Rate Mortgages Bring Financial Peace of Mind

Our financial industry is facing unprecedented financial challenges. One of the primary root causes is that non traditional variable rate mortgages were being made to people that did not understand them. As the payments on these loans increased beyond the buyer's ability to repay the loans, the default rates skyrocketed. The lenders 'creative' business practices and short term financial motivations that led to this fiasco are beyond the scope of this article. This article is directed at the borrower and how to borrow money for a home in the safest manner.

Here is a list and a brief description (and commentary) of some of the riskiest non traditional types of loans:

1. NINJA Loan - No Income, No Job and no Assets - also called the 'liars loan' by industry insiders because few if any qualifications are imposed on the borrower. These loans are also referred to as Alternative-A (Alt-A) loans because they are not made to highly qualified borrowers. These loans come with a high interest rate and fees and are the most lucrative for mortgage brokers. This loan assumes that the borrower will not borrow more than they can pay back. Not a very safe assumption.

2. Balloon Loan - This loan allows the borrower to pay interest only for 5 to 10 years at which point a lump sum payment is due. These loans were designed for people not intending to be in the home for very long. The borrowers gain no equity in the home (unless prices increase a lot in the near term) and better have a large amount saved up in case housing prices fall. This loan is based on the assumption that housing prices will never fall or that the borrower will save a lot of money. Once again, not very safe assumptions.

3. Piggyback Loan - This is usually a loan for 80% of the purchase price coupled with another loan for 20% of the purchase price. The second smaller loan is considered the down payment. This type of loan does not require the borrower to have any of their own hard earned money in the home. When housing prices fall, they owe much more than the value of the home and are more likely to walk away from the loan. Once again, a reliance upon ever increasing home values.

4. Adjustable Rate Mortgage or ARM Loan - The interest rate on these loans fluctuate with current interest rates. Since 2002, we have had the lowest interest rates since the 1960's. So any ARM loans made since 2002 are most likely going to have an interest rate hike. This rate hike translates into a higher monthly payment, causing financial troubles for those borrowers.

5. Teaser Loan - A loan with an artificially low interest rate for two years which then resets to the standard interest rate. These loans are qualified at the teaser rate, so when the real interest rate takes effect the borrower can be in trouble and not able to afford the payment.

6. Stretch Loan - A loan where the borrower is expected to pay over 50% of their pre-tax earnings towards a mortgage payment. By the time all state taxes, local taxes, federal taxes, social security, health insurance, dental insurance and 401K are paid I only receive 62% of my gross income. With this type of loan, my house payment would take 80% of my after tax paycheck!!!

As you can see, any borrowers that chose these types of loans and over borrowed can be in serious trouble. You do not have to make this same mistake - stick with a traditional fixed rate mortgage.

Fixed rate mortgages are usually done over 30 years or if you can afford it, 15 years. If you are someone that does not need to buy near what you can afford, there is tremendous savings by going with a 15 year fixed rate mortgage instead of a 30 year mortgage. This does not include the majority of home buyers.

For reference, here is a table showing the monthly payments on a 30 year fixed rate mortgage of $200,000. This table does not include PMI, insurance or taxes (which are included in many mortgages) - only the payment on the loan.

A $200,000 loan at 4% interest has a monthly payment of $955 and total interest payments of $143,739 while a $200,000 loan at 8.5% interest has a monthly payment of $1538 and total interest payments of $353,614.

As you can see, there is a $500 spread between monthly payments on a loan at 4.0% versus a loan at 8.5%. In addition there is a more than $200,000 difference in the total payoff of the loan. These numbers show the importance of locking in the best possible interest rate on your loan. What these numbers also show is the risk associated with any loan that does not have a fixed interest rate. By not locking in a payment, you risk a huge increase in future mortgage payments. Monthly payments will increase enough just through tax increases, without adding the financial stress of not knowing what your mortgage payment will be each month.

If you are searching for a mortgage loan, it is safest to go with a fixed rate mortgage. Although there are exceptions to every rule, most people are purchasing and moving into a home for an extended period of time. If this is you, do not be teased into buying more home than you need or financing it with an exotic loan just because the bank will lend you the money. They are looking at their short term gains while you must look at your family's long term financial security.