About one third of all homes in the United States are owned free and clear. Said another way, nearly two thirds of homes have one or more mortgages against them. If you are, or will be, in the mortgaged category, there are a few things you should know
The core conditions for any real estate loan are:
- That it will be secured by your real property,
- It usually requires monthly payments,
- It will have a definite, or at least a calculable, interest rate, and
- It will have a specific term for full repayment to the lender.
People finance real estate, whether personal or investment property, to take advantage of the leverage available. You invest just 10% or less of the purchase price from your personal resources and then borrow the rest from your lender. When the market is good to you, this magnifies your return on investment. For example, if you put 10% down and the value of your property increases by 10%, you made 100% on your investment. But, when the market moves against you, the flip side of appreciation is brutal. Suppose you put that 10% down and the property value drops by just 10%. Now you have no remaining equity at all. A 100% paper loss of your money. Of course, if you do not have to sell during the downturn, you don't have a real loss. And, if you wait, appreciation will return. The average rate in the US for the past 100 years or so has been about 3.5% per year.
If you want to use real estate financing on your home, there are two broad options. There are Fixed interest rate loans and Variable or Adjustable interest rate loans.
Fixed Rate Loans:
Fixed rate loans feature a constant interest rate and a constant payment. The rate is a market question and varies hour by hour until you select the loan you want and "lock" the rate when you are ready to borrow the money. The payment results from a formula that considers the amount borrower, the interest rate selected, and the number of months or years payments will be required to reduce the loan to zero.
Fixed rate loan terms are most commonly 15 years and 30 years. However, they are available for 10 years, 20 years, 25 years, and 40 years as well. Generally, the longer the payment period, the lower the monthly payment will be for the same loan. However, as the term selected increases, so does the interest rate charged for the loan. More importantly, the total amount of interest paid will greatly increase the longer term you select.
Fixed rate loans are generally thought of as safe and secure from the viewpoint of the borrower. But, they may not always be the best choice if by best choice one means lowest total cost for the loan over the holding period.
Total cost for any loan over time is equal to the initial cost to borrow the money, the sum of the periodic payments made, and the amount needed to pay off the loan balance, including any prepayment fees.
Variable Rate Loans:
While a fixed rate loan offers a stable payment, regardless of what happens to the mortgage market after the loan is in place, there are some situations where another plan may be beneficial. For example:
- Many adjustable loans have a lower initial interest rate than a fixed rate loan will have on the same day. That means you can obtain a larger loan for the same payment, or the same loan amount for a lower initial payment. The initial period can be selected by the borrower within limits offered by the lender. The initial payment often remains the same for 6 months to one year from the loan funding date, but can run for longer terms such as 3 years, 5 years, or even 10 years.
- Some adjustable loans limit the interest rate change to specific intervals. When the rate changes, the payment also changes to continue to pay off the remaining loan balance over the initial term, commonly 30 years. These changes can be up or down and will follow the reference index for the loan with a fixed spread known as the "margin" established at the origination of the loan.
- Some adjustable loans limit the payment change to a maximum percentage of the prior payment, typically 7.5% of the prior year payment each year. With this type of loan the interest rate can change as often as daily, but monthly and quarterly changes are more common. This type of adjustable loan does include a negative amortization possibility. This means that the amount you owe can increase, depending upon how you manage your loan payment choices.
- Last one to cover here are interest only loans. These can be fixed or adjustable loans. The key consideration is that each payment only covers the interest due since the last payment. Eventually you will need to repay the principle in one large payment, called a balloon payment.
Each of these loans can be a best choice for a borrower, depending upon the borrower's needs and objectives. Only careful analysis of the reasons for the loan and the purpose for the property will provide the best answer for each situation.
