The Case Against The 30-Year Fixed: What You Need To Know About Mortgages In The Current Market
Eugene is the Founder of The Litvak Team @ Compass — one of the top producing and largest teams at Compass.
If you’ve been paying attention to real estate headlines lately, you know that the New York City market is on fire. In the 15 years or so that I’ve been in the business, I’ve never seen anything like the activity I’m seeing now. One of the many factors fueling the current boom is today’s low interest rates. And by low, I mean the lowest rates ever recorded.
That said, too many buyers still believe that a 30-year fixed mortgage is the only option for obtaining a home loan. That’s not only untrue, but it can also be financially detrimental. Whether you’re a buyer/investor yourself or want to be the best possible advisor to your home-buying clients, it behooves you to be up to date on the types of mortgage products available, their benefits and the necessary qualifications.
Types Of Mortgages
Let’s take a look at the very top-line details of the three most common mortgage products available today.
• Fixed-rate: Fixed-rate mortgages offer the same interest rate over the entire life of the loan, meaning your monthly payment always stays the same as well. Fixed mortgages come in terms of 10, 15, 20 or 30 years, with a 30-year fixed mortgage being the most common. Overall, fixed-rate mortgages come with the highest interest rates among the most common loan products, and the shorter the term, the higher your monthly cost.
• Adjustable-rate: As the name suggests, adjustable-rate mortgages (ARMs) feature a fluctuating interest rate. Most ARMs offer a fixed-rate period upfront before the interest rate resets, and many offer a cap that limits how much your interest rate will adjust and how often. Typically, ARMS include a “teaser” rate for 5, 7 or 10 years. A 5/1 ARM, for example, offers a five-year introductory rate followed by a rate that adjusts every year after (that’s where the “1” comes in). The intro rate for an ARM can be 0.5% to 1% lower than for a fixed-rate loan.
• Interest-only: Interest-only mortgages got a bad rap during the 2008 financial crisis, but they’ve been one of my favorite loan products for nearly a decade. With an interest-only loan, borrowers pay only the interest on the loan, not the principal, for a set amount of time, usually five to seven years. Monthly payments are low, and there’s no prepayment penalty. At any time, the borrower can make a large payment toward the principal, and the monthly interest-only payment will be adjusted down. The beauty of an interest-only loan is that because real estate has consistently appreciated over time, as long as your property appreciates by at least 12% (to account for closing costs when buying and selling), you’ll be ahead of the game even with a minimum interest-only payment.
Crunching The Numbers
Let’s face it, the days when someone would buy a home and live in it for the entirety of a 30-year mortgage are long gone, especially in New York City. Here, we expect buyers to stay in studios and one-bedrooms for maybe three years. For a larger apartment, they may stay put for seven or eight years, but virtually no one is living in the same home for more than 10 years. That means there are substantial savings to be had by avoiding a 30-year-fixed loan.
Let’s take the example of buying a $1.85 million New York City apartment — that’s the current median price for a two-bedroom in Manhattan’s Financial District.
A 30-year fixed-rate mortgage at a typical interest rate with a 20% down payment would cost roughly $8,800 per month. A seven-year adjustable-rate mortgage would clock in at about $6,600 per month. Meanwhile, an interest-only loan with a 10% down payment could be as low as $4,400. That means over five years, you could save $264,000 in mortgage payments with an interest-only loan versus a traditional 30-year fixed, and you’d very likely be ahead of the game in terms of the home’s appreciation as well.
The necessary qualifications will vary with each loan product, amount and the type of home you’re purchasing. In general, the more risk involved, the more stringent the qualifications. The standards for an interest-only mortgage will almost always require higher credit scores, higher income levels and more cash reserves and assets than a traditional loan. For example, the minimum credit score for a Fannie Mae loan is 620, but the required score could be closer to 740 for a large, interest-only type loan.
The most important thing you and your clients can do to qualify for the best possible loan product is focus on the six to 12 months leading up to the mortgage application. Make on-time payments, pay down credit card balances, improve your credit score and, above all, avoid any other major purchases during the loan approval process.
I’ve touched on a lot of complicated topics here using ballpark example rates and scenarios. As with all money matters, you should discuss your specific situation with a qualified financial advisor and mortgage lender.
For some, the mortgage process is this dark and mysterious process, so people feel comforted by the idea of a steady, traditional loan product like a 30-year fixed mortgage. But if you take away one point here, it’s that there are other equally sound options available that offer a far bigger payoff.
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