Purchasing a home can be an exciting and rewarding experience, and foremost, represents the single most important and largest investment in most people’s lives. As a result, the process of purchasing a home can be daunting, and if performed carelessly, can be fraught with problems and financial risk. An individual must therefore equip themselves with a strategy and knowledge to prevent a dream from turning into a nightmare.
There are many facets to consider prior to purchasing a home, but one of the most complex and intimidating tasks is evaluating the myriad of financing options. To start, a home buyer must look at themselves in the same perspective a banker will: a quantifiable, risk-based asset that must provide a maximized return. For the most lucrative banking clients, the risk is low and the return is high which results in a large supply of financing offers allowing the client to choose the most competitive. The most competitive offers will be a combination of low interest rates and discounted closing costs. An example of an ideal mortgage loan applicant would have a FICO credit score in excess of 720, a 20% or more down payment, a debt-to-income ratio of less than 36% (less than 36% of the gross income is used to pay a mortgage and recurrent debt), and significant savings and collateral. Bankers also like to make as much money as possible on financing and closing costs to maximize their return. For this reason, bankers prefer low risk applicants with 50-80% loan-to-value mortgages; that is, a large down payment of $145,000 on a $200,000 home would equate to a loan of less than $60,000. Some bankers consider being marginally profitable since fees and interest payments are low. On the other hand, mortgage loan applicants with less than perfect credit, small down payments, or high debt-to-income ratios may have trouble finding banks willing to loan them money. Less than ideal applicants who do manage to find a willing lender will have to pay a premium interest rate due to the higher inherent risk. Therefore, homebuyers must ensure that their financial profile is adequate and acceptable before shopping for financing.
In the mortgage applicant’s perspective, not only is it important to have a low interest rate and closing costs, but to have liquidity available for other purchases, and to eventually be able to pay off the mortgage. One factor affecting this decision is to determine whether it is more beneficial to have a 15 year or 30 year mortgage. Intrinsically, the 15 year mortgage will have higher monthly payments but lower overall interest rates throughout the life span of the loan. Let’s do a simple example using the mortgage comparison calculator using the following inputs:
Mortgage amount: $100,000
Marginal tax rate: 25%
Interest rate for 15 years: 4%
Interest rates for 30 years: 4.5%
The calculator reveals a $233 difference in payments with a monthly payment of $739.69 for the 15 year mortgage, and $506.69 for the 30 year mortgage. By clicking “view report” on the mortgage comparison page, it is also evident a significant difference in total interest payments over the life of the
mortgage of $33,144 for the 15 year mortgage versus $82,405 for the 30 year mortgage. It therefore makes sense for home buyers who have the financial means to make the more expensive mortgage payments should opt for the 15 year mortgage and save $49,261 in total interest.
Another strategy that a home buyer can consider is choosing the 30 year mortgage and making additional principle payments when money becomes available. In this way, a home buyer is not bound to a high monthly payment required by the 15 year mortgage which could prove to be a wise choice since no one knows for sure the stability of one’s income over a long stretch of time. Therefore, let’s do another calculation using the following mortgage payment calculator using the following inputs:
Mortgage amount: $100,000
Mortgage term: 30 years of 360 months
Interest rate: 4.5%
Extra monthly payments $233
Notice that by making the extra monthly payments equivalent to the difference in our first scenario, the lifespan of the loan is only nine months more than a 15 year mortgage. Additionally, the total interest paid will be $39,754 or $6610 more expensive than the 15 year mortgage. Therefore, for some homebuyers, not being bound to a higher monthly payment with a 30 year mortgage may be more desirable since making extra principle payments is roughly equivalent to the 15 year mortgage though with lowered financial risk and obligation.