How Come a Lender Can Offer Me a Higher Rate, But With Lower Monthly Payments?
Lenders have been introducing more and more loan products recently to attract buyers by giving them more purchasing power. The traditional mortgage, whether fixed or adjustable, has a term of 30 years. Many other terms (5, 10, 15, 20, 25 years, etc.) are available, but when comparing lender quotes, a 30 year term is pretty much standard. Also, most loans are have a normal amortization schedule, meaning you begin paying down the principal (albeit a small percentage) with your very first mortgage payment.
How Amortization Can Affect Your Payment
Let’s use an example. You are purchasing a $250,000 house and are able to put $50,000 as a down payment. That means your Loan-to-Value ratio is 80% and your new loan is for $200,000. You are quoted a zero point loan with a 30 year term at 7.5%. Your monthly payment (excluding any taxes or insurance) is $1,398.43
Suppose you don’t plan on living in that house very long and would like to lower your monthly payments. Most borrowers keep their mortgages for 5 to 7 years anyway, and there’s a possibility interest rates may change or you may move to another house. Your lender may suggest a 40 year term mortgage. The lender may charge an additional 0.1% to extend the term, bringing your rate to 7.6%. Your new monthly payment would be $1,330.95. Even though your rate is slightly higher, because you are stretching out your payments over an additional ten years, your monthly payments end up being lower.
50 Year and 40 Year Terms
In the past year or two, 50 year term mortgages have been more common for the same reason 40 year mortgages rose in popularity. The lender is willing to extend your term to 50 years, but will charge 0.25% over the 30 year term rate. This brings the interest rate to 7.75% and the monthly payment down to $1,319.
Loan Terms
Keep in mind that not all lenders offer these longer term mortgages, and most of them charge a different amount onto the interest rate for these products. The examples used were based on Adjustable Rate Mortgages. Increasing the term on a fixed rate loan generally costs more (often 0.8% to 0.9% higher). Another very important aspect to keep in mind is whether or not there is a “balloon” payment due after 30 years in a 40 or 50 year mortgage. Although very few people will retain that mortgage for the life of the loan, the lender may call the loan in after 30 years. Many “40 year mortgages” simply mean they base the monthly payments as if the loan were to be due in 40 years. This is often not the case, and the actual term of the loan on a 50 or 40 year mortgage is 30 years. These types of loans are often referred to by lenders as “40/30’s” or “50/30’s”. Be sure to ask your broker or lender about an possible balloon payments.
Interest Only Loans
Aside from extending the term of the mortgage, another easy way to lower your monthly payments is to obtain an interest-only loan. These loans can be fixed or adjustable and some are even available with 40 year terms. In an interest-only loan, you can pay only interest (not principal) at the beginning of your loan. Keep in mind that you can pay more than the minimum payment, which will be applied directly to reducing your principal. If you are still in a pre-payment penalty period however, you will probably be limited to being able to pay 20% of the total balance of your mortgage per year, which is often not a problem! Interest-only periods vary, but are commonly five years long in the subprime market. There are several advantages to interest-only loans, but they need to be matched with the right borrower.
Let’s use a similar example. You are taking out a $200,000 loan at 7.5% on a zero point loan with a 30 year term. The lender will allow you to make interest-only payments for the first five years of the loan in exchange for a rate increase of 0.25%, bringing your rate to 7.75%. Now, your rate is higher, but your monthly payment is only $1,291.67 as opposed to $1,398.43 with a regularly amortizing loan at 7.5%. That’s a savings of over $100 a month and over $6,000 over five years! Keep in mind though that when your interest-only period is up, you are still stuck with the higher rate (if your rate is fixed). And if it’s an adjustable rate, the combination of the two increases in your monthly payment can spell trouble. Review all of this carefully with your lender to make sure you are able to assume the risks associated with these products.
Interest Only Payments are Tax Deductible
A final benefit of interest-only mortgages is that your entire monthly payment is tax deductible because mortgage interest is tax deductible (with a few exceptions, such as 125% loans). Also, purchasing a home in a neighborhood where property values are increasing can help speed up the appreciation of your home and offset the fact that you are not paying down principal at the beginning of the loan. Used wisely, extended term and interest-only mortgages can allow you to purchase the home of your dreams and not just the home you thought you had to settle for.
