The Home Mortgage—One Size Does Not Fit All

The housing market has shown a slight uptick in the past two years, arguably bolstered by robust hedge fund investments in single family homes. That said, housing is contributing less to the Gross Domestic Product (GDP) than at any time since the Second World War. Once, in the early 1950s, housing was nearly 7.25 percent of our economy … now it is 3.11 percent. The health care industry has become the largest segment of our GDP at well over 17 percent and is expected to reach 20 percent over the next seven years.

That said, we all need a roof over our heads, and for many, the American Dream remains home ownership. If you have made the decision to buy a home, be certain the financing you arrange is a good fit for your budget, your work and your future financial aspirations.

Finding the Right Lender

Finding the ideal lender is not always an easy task. For example, if you are buying a bank-owned property (that’s PC speak for foreclosed home), the ideal lender is the selling bank. They will be more likely to forgive any shortcomings that might show up in your credit profile because they are motivated to sell the property. You may also be in a stronger position to negotiate rates, points and other fees.

On the other hand, if you’re not buying a foreclosed home, the best place to begin is a bank with which you have an established relationship. This relationship could be in the form of an auto loan, checking or savings account, safe deposit box or certificate of deposit. Of course your realtor will have options as well, but be cautious. These are frequently “I’ll scratch your back if you scratch mine” relationships and not necessarily your best option. This is a major transaction, so by all means, shop around.

Getting the Right Terms

You must consider is what type of mortgage is best suited to your current needs and future goals. There are several types of mortgages available. There are fixed-rate mortgage loans, adjustable-rate mortgage loans (ARMs) or hybrid ARMs. Hybrid ARMs are mortgage loans that have interest rates that are fixed for an initial period (typically three, five, seven or 10 years) and, thereafter, reset at regular intervals subject to interest rate caps.

In my view, regardless of your current needs and goals, the fixed rate mortgage is the absolute best choice at this juncture. Here’s why. Mortgage loan rates are at the lowest levels since 1971. In short, the only direction they are likely to move from here is up! A 30 year fixed rate mortgage loan is available at around 4.3 percent. Shorter term loans have rates that are even lower. As a result, there is no reasonable argument for any of the more exotic mortgage loans available. They only allow your rate to increase as rates rise. Why would you want to do that?

The next decision you must make is the term; that is to say, the length or duration of the loan. Fixed rate mortgages tend to have 30, 25, 20, 15 or even 10 year terms. I recommend that your mortgage payment should not exceed 25 percent of your income. On that basis, choose a term that meets this objective. Your lender can calculate payments for various terms or go on the internet and find a mortgage loan calculator that allows you to do this for yourself.

Financial Consequences

In the current economic climate, mortgage lenders of all stripes have significantly tightened lending policy. Conservative lending is the norm these days. If your credit record, employment history, income, references and down payment are not up to par, it is very probable that your loan will not be approved. Alternatively, you may receive an approval, but at a higher interest rate. Remember, rates are a function of risk. If the information in your credit profile suggests a higher than average risk as determined by your credit score, you can expect to pay a higher interest rate. If you fall into this higher risk (low credit score) group, you may be better off deferring your home purchase until you can bring your credit score and other aspects of your credit profile to a higher level. Allow me to explain why.

In this example, the calculations are accurate, and meant to illustrate the impact of paying a 1 percent per annum higher rate of interest. In our example, you will be financing a modest $75,000 dollars over a twenty year term, which equals 240 monthly payments. If this loan is approved at 4.5 percent, you will pay $474.49 per month. However, if the loan is approved at 5.5 percent, your payment will be $515.92 per month, a difference of $41.43 per month. This may not seem like much, but multiply that by 240 payments and you are looking at an increased cost of $9,943.20 over the life of the loan! Naturally, the larger the loan is, the greater the difference. This example quantifies the impact higher rates have on your cost of borrowing.

Final Thoughts

In closing, I will offer a few words of caution. Your home is more than an investment. It is a place to raise your family. For many, it is the main part of their wealth, and something to fall back on in an emergency. You can sell the house or take out a second mortgage to access your equity and pay for something that’s more important to you.

But the investment has another nuance—is it a good investment in the sense that it will provide you financial returns? This is no longer something we can take for granted. It may be years before housing recovers. There is no guarantee that housing will ever recover fully. In short, be realistic with your expectations. At best, you may see your home appreciate in value as the years go by, creating a nest egg for retirement, your children’s education or other goals you may have. At worst, you will have lived in a place of your own and didn’t spend your money making a landlord wealthy. At either extreme, you could do a lot worse than buying a home of your own.

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H. D. Carver is an American who currently resides in Cagayan de Oro City, Philippines. He has years of experience in the financial services sector and has served as a manager for Fidelity, as the vice president of a large regional bank, as the president of a financial services company, and as the Manager of Administrative Services and Support for the Aon Corporation. He has worked as a freelance writer for 4 years. Currently, he writes for Your Finances Simplified.