Lenders now offer mortgage products that were unheard of a decade ago. It used to be that if you wanted a 30-year fixed-rate mortgage, you had to be able to qualify to make a 30-year fixed-rate mortgage payment. That has changed, at least with some lenders.
In mid-November, interest rates hovered around 6.5 percent for 30-year fixed-rate mortgages. While this is still low in historical terms, 30-year fixed-rate financing was available for about 5.6 percent a year ago.
Until recently, most home buyers opted for a hybrid adjustable-rate mortgage (ARM). With a hybrid ARM, the initial interest rate is fixed. Before short-term rates started to climb, buyers were able to get a hybrid ARM with an initial rate well below the rate charged on a conventional 30-year fixed-rate mortgage. The lower monthly payment made it easier to qualify for a larger mortgage.
As home prices escalated, hybrid ARMs became popular because they expanded a buyer’s purchasing power in the face of rising home prices. However, with a hybrid ARM, the interest rate is not fixed for the entire term of the loan.
The initial rate might last for three to 10 years. But, after the initial fixed-rate term expires, the loan converts to an ARM with an interest rate that adjusts up or down to reflect changes in the finance markets. So, at the end of the initial fixed-rate period you could end up with a much higher interest rate.
Hybrid ARMs look less appealing now that interest rates are finally rising. At present, there’s little if any initial rate discount offered on hybrid ARMs. A 30-year fixed-rate mortgage at close to 6.5 percent looks appealing compared to the risk of paying a much higher interest rate in several years.
An issue for many buyers is qualifying to make 30-year fixed-rate mortgage payments. To meet this need, lenders have come up with a 30-year fixed rate mortgage product that gives borrowers the option of making interest-only payments for up to 15 years.
To sweeten the deal, lenders qualify borrowers based on the interest-only payment, which is lower than a fully amortized payment. This means that you can qualify for more while paying less, which is fine as long as you understand the risk.
A fully amortized mortgage pays back some of the amount borrowed (called the principal) with each monthly payment. So your remaining loan balance decreases over time. Your loan balance does not decrease when you make interest-only payments.
If you were to make interest-only payments for 15 years, you would still owe the original amount you borrowed at the end of that time. You’d have to pay the principal back in half the time. To accomplish this, your monthly payment would have to rise significantly.
HOUSE HUNTING TIP: If you do choose a 30-year fixed-rate mortgage with an interest-only payment option, make sure it doesn’t have a prepayment penalty. This way you can make additional principal payments at any time and avoid the risk of a huge payment shock when the initial interest-only payment option expires.
There are risks involved with this kind of mortgage. But, there are benefits, particularly for buyers who are fiscally prudent, have limited resources and who expect their income to change for the better within a few years.
Qualifying is easier, the interest rate is fixed at a relatively low rate and the payment options are more flexible, at least at the beginning. This could enable you to buy a more expensive home that would suit your needs for the long run.
THE CLOSING: For most borrowers, the key to success with this type of mortgage is to increase the amount you pay per month as soon as you can.
Dian Hymer is author of “House Hunting, The Take-Along Workbook for Home Buyers” and “Starting Out, The Complete Home Buyer’s Guide,” Chronicle Books.
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