Financing Your Home
Home loans are usually a major component of financing your home. Since most people cannot pay for their homes with cash up front, they need to finance their home over a period of time using a home loan. However, there are different kinds of home loans you can get depending on your individual needs, so it is important to understand the various different kinds of loans that are available to you.
The most sensible loans are fully self-amortizing, have a fixed interest rate and have constant payments. "Self-amortizing" means that each payment pays more than is owed for interest. The extra amount is called a principal payment, and it pays down the balance of the loan. To be fully self-amortizing, the entire balance of the loan would be paid down with fixed payments by the maturity of the loan. An ideal loan will also have a fixed-interest rate that does not change with time. Having a fixed rate provides some certainty about how much a home loan will cost per month. This certainty allows for future planning. Constant payments force you to start making sacrifices now instead of waiting to pay later. The sooner you make payments on your loan, the less it will cost you in interest over time.
There are many kinds of home loans that should be avoided by most people. Adjustable-rate loans should be avoided, because any spikes in the interest rates will result in the borrower paying more per month. There is no way to know what interest rates will be in the future, and non-finance professionals are not qualified to try to manage interest-rate risk. Yes, rates for adjustable-rate loans typically start out lower than fixed-rate loans, but the catch is interest-rate risk. In effect, banks charge a slightly higher rate for fixed loans than they do for variable-rate loans, because lending at a fixed rate makes them bear interest-rate risk instead of passing it on to the borrower.
Opt for a traditional fixed-rate mortgage. While this kind of mortgage comes in several different lengths of payment term, the most common of these are the 10-year, 15-year and 20-year varieties. It is interesting to note that during the early parts of your loan, most of the money you pay goes into the loan's interest charges. So, when you are 10 years into a 20-year mortgage loan, you will only have paid 25% of the principal instead of the half that you might expect based on the loan's duration. Your monthly payments are fixed for the life of this kind of loan, though you can generally overpay and finish the loan off before its originally intended due date.
Tactics for Saving Money
There are tons of different ways you can save money, both on your way to getting a mortgage and once you have one and are working to pay it off. The nature of having a mortgage is that once you have it, you would be wise to pay it down swiftly if it is at a higher rate of interest than your savings receive. Even if your mortgage is very reasonable and you are easily paying it down faster than you need to, there is always a good reason to save money. The hard part tends to come down to how.
You can save in a lot of ways, particularly with regard to your mortgage. Here are some of the best ways:
Pay more than you need to each month. Since mortgages are weighted more toward interest payment in the beginning, every dollar you pay in the first few years will save you a few dollars in interest across the life of the loan.
Start paying before the requirement. Generally, you get between one and three months where you do not have to make a payment at the beginning of your loan. During this time, every day, interest is still accruing on your loan. If you pay that extra two months, you'll save almost six months off of the end. Hopefully, you've already got your finances sufficiently in order to make your monthly payments before your loan has started.
Start automatically saving. If you don't have a bank account, get one. Then start transferring a part of every paycheck into a second, separate account that makes accessing your money difficult. This will form a strong base that you can use to save for anything: your home's down payment, an extra payment every year or a roof or A/C repair when the time comes. Making saving automatic makes it easy, and easy things happen slowly but surely.
Make sure you get the lowest fees possible. If a fee looks suspect, don't be afraid to walk away. They can't make you sign, and you have a right to avoid potentially thousands of dollars worth of nonsense fees that some companies like to try and impose.
Shop around for the best rate. One or two percentage points lower can sometimes save you tens of thousands of dollars across the life of your loan. A few extra minutes can be extremely profitable this way.
Shop around for refinancing opportunities.
Types of Loans to Avoid
Loans that either delay payments or make the borrower dependent on future interest rates should be avoided. These attributes make borrowers more dependent on unknown future circumstances: their ability to make bigger payments in the future or future interest rates. Unfortunately, there are many kinds of loans with these attributes:
Adjustable-rate mortgages (ARMs) should be avoided, because any spikes in the interest rates will result in the borrower paying more per month. There is no way to know what interest rates will be in the future, and non-finance professionals are not qualified to try to manage interest-rate risk. Yes, rates for adjustable-rate loans typically start out lower than fixed-rate loans, but the catch is interest-rate risk. In effect, banks charge a slightly higher rate for fixed loans than they do for variable-rate loans, because lending at a fixed rate makes them bear interest-rate risk instead of passing it on to the borrower.
You should also not take on a loan with a teaser rate or teaser payment. These loans have introductory periods with lesser payments before larger payments become due at a specified date in the future. These loans may seem harmless, but they encourage borrowers to put off paying their loans into the future. Many people take on these loans with the notion that their futures are guaranteed to be brighter and that making payments in the future will be easier than making them today. Worse yet, some people use these temporarily low payments to borrow more than they would if they had borrowed using a fixed-payment loan. Financial planning is not about pushing responsibility into the future nor is it about risking default by living beyond your means. If you can't make payments now, don't take on the loan. You don't know the future. If you can't make payments today you don't know if you can make them tomorrow.
"Balloon" or "bullet" loans should be avoided. A balloon payment tends to come at the very end of a loan that has small monthly payments, and it involves a promise that you are going to pay a large amount of cash at the loan's termination. One common balloon payment loan is a 5/15 loan. The first number, five, refers to the maturity of the loan. The second number, 15, is the number of years the due payments would take to buy down the loan.
Since the scheduled payments would take 15 years to pay down the loan and the loan balance is due at maturity in 5 years, most of the balance of the loan is due all at once, in five years. Most borrowers do not have enough money to pay the majority of their loan all at once and are forced to find a loan at maturity to pay off their existing balance. This forced refinancing is very dangerous, because it makes the borrower dependent on the interest rates that prevail five years in the future, at the maturity of the loan.
No one knows what they will be! What if banks aren't lending in five years?
An interest-only loan does not pay down the balance of a loan, so the amount that the borrower owes does not go down. At maturity of the loan, the borrower would somehow have to come up with the entire balance of the loan. This is worse than a partially paid balloon loan.
An even worse kind of loan is a negative-amortization loan, which has payments that do not even cover interest! This kind of loan increases the balance the borrower owes over time. This is terrible, because it compounds more and more interest for the bank and grows a bigger payment that will eventually come due all at once!
Loans with long maturities should also be avoided. Loans with 30-year or 40-year maturities extend payments into an uncertain future and grow more interest for the bank. Your job could disappear in a year. Your profession could disappear in a few years,. Your entire industry could disappear in a few decades. How could you possibly enter into a contract to make payments in 30 or 40 years? For most borrowers, a 40-year loan would mature into their retirement! This is silly.
Loans with prepayment penalties should be avoided. Prepayment penalties charge borrowers a percentage for early payment. These penalties punish you for trying to avoid future interest expenses by paying down your loan early. They also punish you for paying off your loan early in the event that you sell your home or refinance your mortgage.