The Perfect Mortgage
Learn how to choose a mortgage that fits your personal needs, life goals and financial situation.
There’s no such thing as a one-size-fits-all mortgage. Each situation and circumstance dictates what type of mortgage is the best fit for a consumer’s unique needs. A person’s age, work status, financial goals, how long they plan to live in a home and many other details dictate the type of mortgage they should choose.
And although many people come into a bank knowing what they want, it’s worth getting additional advice from an expert before making any decision, suggests Brad Strothkamp, a principal analyst with industry research firm Forrester Research. “People have a tendency to overestimate how smart they are about mortgages, but things have changed,” he says. “It’s more difficult to get a loan today than it was three years ago, and people need to be aware of what that process involves.”
BethAnn Ericson, a personal banker with First Midwest Bank, in Gurnee, IL, agrees. “There are so many considerations that lead to choosing the right mortgage,” she says.
Ericson specializes in residential mortgages and works closely with her customers to help them assess the various options available to them, while helping eliminate any misconceptions or concerns they might have. “We remove the scary terms and focus on their personal goals.”
Every consumer and every circumstance is unique, but borrowers should consider these common scenarios when selecting a mortgage.
30-Year Fixed: Best choice for first-time homebuyers
“Younger people often want to overextend themselves on their first mortgages,” Ericson notes. When she works with young buyers, she begins by helping them plan a budget that defines their household income and debt – including college loans – so they understand what their costs will be. She may also help them create a savings plan to accumulate a down payment. “I want them to know that when they go to sleep at night, everything is fine and their new home is soluble,” she says.
She encourages first-time homebuyers to choose a 30-year fixed mortgage, which secures a fixed rate for the life of the mortgage because it’s the safest, lowest risk option – unless they have distinct plans to move in the next couple of years.
15-Year Fixed: Long-time homeowners can shorten their payoff
Refinancing a 30-year mortgage into a 15-year fixed rate mortgage is a great choice. In this market the right candidates can reduce their fixed interest rate by 1.5 to 2 percent and maintain a similar monthly payment, while speeding the time to pay off their home by years. “That makes a heck of a lot of sense,” Ericson says.
But it’s not attainable for everyone. A good candidate has been in their home seven or more years, is able to keep their payments roughly the same based on the interest rate they can get, has good credit, a strong income and only a moderate amount of revolving debt.
Adjustable Rate Mortgage (ARM): A good option for short-term homeowners
An ARM is a mortgage with an interest rate that fluctuates based on an economic index. It may offer a low rate to begin with, but can bounce wildly over the course of the loan.
ARMs are appropriate if the homeowner plans to spend less than three years in a house, or for homeowners who have overextended themselves and want to use their equity to pay down debt while they attempt to sell the house. In both cases, this is a short-term solution, and only appropriate if a homeowner has the confidence that the home will sell.
Ericson warns that many homeowners with five-year ARMs in this economy have been unable to sell their home in time, causing the ARM to run out and their interest rate to jump. “You’ve got to understand the resale value of the community when you choose an ARM.”
An ARM can also be a viable solution in conjunction with a smaller second mortgage or home equity loan/line of credit, to keep the primary mortgage under 80 percent of the value of the house, in order to avoid PMI. In addition, by utilizing an ARM first mortgage, the consumer can take advantage of lower payments in the first years of ownership – but only if the consumer is able to pay it off or refinance to a fixed mortgage in a short amount of time.
John Stedel, a professor at Chicago State University chose this option when he refinanced his home in Antioch in 2010. He secured a 15-year fixed mortgage, but because the value of his home had fallen, he needed a $20,000 home equity line of credit (second mortgage) to be subordinated behind the 15-year first mortgage to make the refinance work. “Although the interest rate for the home equity line of credit is slightly higher than the 15-year fixed, it’s variable based on the prime rate, so we plan to pay that off as quickly as possible,” he says.
Deciding between a fixed-rate mortgage and an ARM depends on the situation, Strothkamp says. “If you’re going to be in your house long-term, a fixed mortgage is a wise choice,” he says. “But if not, an ARM may be the better option.”
Home Equity Line of Credit (HELOC): A solution for homeowners looking to remodel
If customers have equity in their home and want to either boost the value of their property or use that money for other costs, a HELOC is a good choice.
A HELOC is a second mortgage that offers a line of credit to the consumer up to the amount of the loan. Like a bank account, the money is there to be used or not, and it can be paid back and reused again. It is backed by the value of the home.
A lot of people still use HELOCs for home improvement, and may take more than the cost of the project to cover surprise expenses, or to begin paying down the loan. “That’s what home equity lines were designed for,” Ericson says.
In the recent past, people used HELOCs more frivolously, using the money with no plans to repay it because they assumed their home values would continue to rise. But not any longer, Ericson says. “When utilized in a productive way, HELOCs are a good recommendation, but the days of borrowing against equity and making interest-only payments are over.”
Refinancing: For homeowners who want to lower costs, but aren’t upside-down on their mortgage
Many consumers are refinancing to take advantage of low interest rates, but consumers have to educate themselves about the costs of a refinance, the interest rates available, and the current price of their home to be sure the outcome is worth the effort.
Refinancing may be a good idea if the consumer is attempting to recoup their costs in savings through a lower interest rate in six months or less, says Ericson. So for example, if the refinance process costs $500, and the new interest rate lowers the monthly payment by $100, that makes sense because the costs are covered in five months. On the other hand, some consumers may have the capacity to break-even on their costs over a longer period of time, say 12 to 24 months. In any event, each individual situation is different and it depends on the consumer’s financial goals on the acceptable time period to break even on the costs of refinancing.
Consumers also have to realize that because housing values have dropped, a refinance is not always possible. “You can’t take advantage of lower rates if you are upside-down in your mortgage,” Ericson says.
Reverse Mortgages: A smart tool for seniors
A reverse mortgage is a great way for seniors age 62 and older to tap into their equity without having to sell their home and move out. At the same time, a reverse mortgage does not require income verification or a credit score and allows for any existing mortgage payment to be eliminated if the homeowner wishes to do so.
Furthermore, these mortgages can make seniors more comfortable in their retirement by giving them an added source of income, but they need to understand the risks. They are taking a line of credit, lump sum or receiving fixed-income payments based on the value of their home against a lien on the mortgage. They don’t have to repay that loan, but it diminishes the equity in the home. When the homeowner dies, it then becomes the responsibility of the estate or family to repay the loan, or sell the house.
Some family members may object to such a choice because it reduces the value of their inheritance, but as long as the homeowner is of sound mind and comfortable with the decision, it’s a nice way for people to live out their senior years in comfort and with the peace of mind that they never have to make a mortgage payment for as long as they live in their home.
How to Choose
Regardless of mortgage type, it’s important for consumers to take the time to educate themselves and talk with a professional about their options. And the sooner they do that, the better, says Ericson. “There’s a misconception that you need money in the bank before you can come in to talk about a mortgage. But even if someone is two years away from making a commitment, that’s fine,” she says. “I can help them create a wealth plan that will get them to their goals.”
She also warns consumers that they should never feel bullied into a mortgage that doesn’t feel right to them. “You are not buying a used car; you’re getting a mortgage,” she says. “You should feel like this decision is as important to your lender as it is to you.”