Deciding on Mortgage Options

If you are looking to get a mortgage to purchase a home, the first thing you’ll need to decide is how much of your own money you’re going to put on it initially, called the down payment.

Many people think that the more you put down on a purchase, the smaller your mortgage will be, and given that smaller mortgages are better, they should put down as much as they can or are comfortable doing.

Deciding on Mortgage OptionsThis isn’t necessarily the case though as it is generally a good idea to have funds in reserve, for several reasons. Aside from needing funds for closing costs, it’s a good idea to have a fund set aside for repairs as well as for life’s other expenses.

Even though a purchase may have nothing to do with your home, if you are going to have to borrow for it, this is going to involve higher to much higher rates than is charged for mortgages. If you don’t have the means to borrow for the purchases, you will then have to arrange for credit to buy them, or if you can’t, you will simply have to do without.

So, it makes sense not to throw your last dime on the down payment, and preferably you would be able to not only set aside a portion of your capital for other purposes other than the down payment, you’d also want to be able to set aside from savings each pay for this purpose as well.

Should your reserve grow to the point where you could very comfortably use some of it to pay down your mortgage, just about all mortgages have pre-payment options and they are usually pretty generous, as in 10 or 20% of the original principal of the mortgage per year.

Money put on your mortgage cannot be reclaimed though without refinancing, so you do need to be careful not to be overly aggressive with your pre-payments, and end up with situations where you prepaid to save 3% a year and then later have to turn around and borrow this money you put on the mortgage at 10 or 20%.

So, you should be looking to make your down payment very comfortable, to properly account for managing your overall finances going forward, not just the mortgage.

Choosing Your Mortgage Amortization

The next thing to decide is how long you want to be able to take to pay off your mortgage should you just make the minimum payments. Once again, a lot of people seek to be overly aggressive with this and don’t fully understand what they are choosing here and what the ramifications may be.

The biggest thing to understand about amortization with a mortgage is that this does not determine how long you will take to pay your mortgage, as you can pay off a mortgage very quickly even with the longest amortization allowed. Mortgages offer both generous pre-payments and the ability to increase your payment as well, and both of these together allow people to pay off their mortgage very quickly if they have the desire and the ability to do so, without even paying any penalties for early payment.

The amortization sets the minimum payment though, the amount you have to make each period to not lose your home. This should not be set aggressively, because when you do, you are just asking for trouble.

Many people set their mortgage payments too high, where they could have been set lower, and then end up racking up debt with a much higher interest rate. It does not make sense to pay extra money on a very low interest mortgage and then turn around and need to borrow this money at a much higher rate.

Banks don’t mind you doing this though, so they usually don’t advise you properly, although most mortgage advisors don’t have a very good idea of how this all affects people anyway. Mortgage advisors are trained to sell mortgages though, they are not financial advisors, and therefore the proper allocation of one’s income is just not part of their training.

Having too large mortgage payments is by far the biggest mistake people make, and as a good rule of thumb, it is almost always preferable to always go with the maximum amortization, unless one can very comfortably pay more.

This means that it is not conceivable that they would ever be in a position where they would regret paying more, and that’s not a lot of people. It’s usually a lot better to set the minimum payments lower and then use voluntary payment increases to get the payment to where you want it.

This gives you the option to set it back down later if needed, which is an option that is often needed by people as their financial circumstances change over time. You can’t ever set the payment lower than the original amount based upon the chosen amortization without completely re-doing your mortgage, which is expensive to do and you should never refinance when you don’t need to.

If you wish to be aggressive with your payments, it’s important to be aggressive with the right things. A lot of people don’t think very far into the future when they get credit, and you have to account for future borrowing as well as current borrowing, and paying too much on your mortgage at the expense of other credit products is a very common mistake.

Choosing Between a Fixed and Variable Rate

Fixed rates assign interest rate risk to the lender, where the borrower locks in a certain rate over the term of the mortgage. Variable or adjustable rate mortgages are based upon an interest rate benchmark, and move up or down with changes in interest rates overall.

Variable rates are set by way of a specific spread from the benchmark, and therefore move in lock step with this benchmark. Fixed rates are set at a specific rate which remains in effect regardless of fluctuations in the interest rate market.

Many people don’t give this much thought, and lenders don’t really either, who may see this as more of a matter of borrower preferences or risk tolerance. It’s not that these things don’t matter, it’s that they aren’t the only consideration.

If one is particularly risk averse, then this can be the deciding factor in choosing between fixed and variable, and in this case one may be almost forced into choosing a fixed rate. This risk aversion should be based more upon the borrower’s objective conditions rather than just an unreasonable fear or risk, although that needs to matter as well.

Risk aversion is often based upon a lack of understanding of the risks though, and it’s this part that isn’t preferable, as this can cause one to make the wrong objective choices and be worse off financially on balance.

A lot of what goes into this decision depends on the outlook for interest rates over the term, and we can’t just assume that the risk is properly priced in, such that either choice will yield a similar cost in interest on the balance of probabilities. If interest rates can only go up for instance, and the gap between variable and fixed rates is rather small, it can even be foolish to ever choose a variable deal.

Choosing the Term of Your Mortgage

With some mortgages, the term and the amortization are the same, and for those, choosing the term becomes a pretty simple matter, you don’t have to choose at all actually once you have carefully chosen the amortization of your mortgage.

In other cases, the term is chosen separately and tends to be of a shorter duration. Your amortization may be 25 or 30 years but your term might only be a year or two, or more typically, 5 years.

The term designates how long you sign up for so to speak, where at the end of the term you can transfer your mortgage or make whatever sort of extra payments on it as you choose.

There are some benefits and pitfalls of having a shorter term. Longer fixed terms represent more risk to the lender and this extra risk will of course be priced into the rate, so the longer the term generally, the higher the fixed rates will be.

Longer terms benefit borrowers because they reduce risk, transferring the risk to the lender, but you’ll pay for this generally with higher rates. Shorter terms are more predictable and also offer better rates to the borrower, but sometimes at a price if the rates are higher at the end of the term and one would have been better off choosing a longer term.

When people have the choice, most choose the middle ground, for instance going with a 5 year term where the options are between 1 and 10 years. This seeks to strike a balance between rate security and rate pricing, and makes sense from an equilibrium perspective.

Each term needs to be looked at separately though, to compare the desirability of each, and sometimes lenders will have special pricing for certain terms, usually the popular ones, which then become an even better deal.

With variable rate mortgages, the term determines the interest rate spread, which does fluctuate based upon market conditions. Usually there is just one term offered for variable rate mortgages though, which does simplify things.

The main thing to focus on when deciding between mortgage options is to make sure that you get this comfortable, and not set your payments too high. Lenders don’t mind when you do though as this makes it more likely that you’ll be knocking on their door to borrow again, whether that’s with an unsecured product or having to refinance your mortgage entirely to make up for poor decisions.

John Miller


John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

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