Financial Planning for May 2006

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Financing Your Home
Well, you’ve done it now. You’ve gone out and found the house of your dreams. It’s got just the right number of rooms, square footage and it’s in a great neighborhood. There’s just one problem, though. How do you pay for the house if you’re not rich? That’s what this article plans to explore this month.

There are a number of considerations when deciding on the type of financing for your new home. The first deals with your present circumstances. Do you presently own a home and the mortgage to go along with it? Can you afford to carry both your present home mortgage and a new one? Do you need the equity in your current home in order to make the down payment on your dream home?

Let’s assume the worst case. That is, you can’t afford to pay two mortgage payments and you need the equity you’ve built in your old home to make the down payment on your new home. Are you out of luck until your old home sells? As fate has it, you may not be.

Assuming you have the income to support it, you might be able make a bridge loan. This is a loan that will help you borrow against the equity in your old home to allow you the funds to purchase your new home. At the same time, you can restructure the debt on the old home to an interest only payment quarterly with principal payable at some future point. The idea is to give you the funds you need to purchase your new home while giving you some time to sell your old home before having to make a payment that could bust your budget.

Bridge loans can work well for many people, but they are risky. Before you chose this route, take a look at the market you are in. If you are in a hot market where homes stay on the market a short period of time, this is a viable route. If the market is soft, you may want to wait until your home is sold before purchasing a new home.

Suppose you don’t need to worry about selling an old home or you are otherwise ready to move forward with purchasing a new home. What is the best financing route for you?

To start off with, there are two general types of loans you are likely to run into. The first is an Adjustable Rate Mortgage (ARM). An ARM does what its name implies. It generally starts off at a lower rate and, within a set period, the rate is adjusted based on some identifiable loan index. There are limits to how much an interest rate can change in a given year and there may also be a point cap that will limit the total increase in interest rate over the life of the loan. For example, if you start with a 5 percent loan and a 5 point cap, the highest your interest rate will ever be is 10 percent.

The second type of loan is the Fixed Rate Mortgage. The interest rate on this type loan never changes. The down side to a fixed rate mortgage is that the interest is generally higher than the first year rate for an ARM. This is because the mortgage company is pricing the loan based on the current market rate whereas the ARM is based on a lower rate and the mortgage company is betting it will make up for the lower rate as the rates change in the future.

Within the general types of loans, there are various terms available. One you see a lot of these days is the interest only loan converting to interest and principal at some point in the future. The advantage to this type loan is it lowers your payments in the early years. A downside to this type loan is it also extends the time period you will be paying on your loan.

So what’s better, a fixed rate mortgage or an ARM? The answer is that it depends. It depends on the initial interest rates, when the ARM rate will change and how long you plan to be in your new home.

You can expect the ARM interest rate to be lower than the fixed rate to start off. If you don’t really plan to be in your home for more than the period the initial rates remain the same, you are probably better off going for the ARM. As an example, take a $200,000 loan. The current market rate at the time of writing this article was 6.15 percent for 30-year fixed rate mortgages and 5.81 percent for a 5/1 ARM. A 5/1 ARM is one where the initial rate remains the same for 5 years and then adjusts every year thereafter. This illustration assumes that after the first 5 years, interest rates go up .5 percent each year to a maximum of 12 percent.

If you plan to live in your home 5 years or less, you are better off with the ARM. The monthly payment will be $43.68 less than under the fixed rate mortgage and over the 5 year period, you will save $2,621. If you plan to live in your home for a much longer period, say thirty years, then the fixed rate makes more sense. In this example, total payments would be $438,642 for a fixed rate mortgage and $573,611 for the ARM.

The example assumes that interest rates will eventually move to a relatively high rate (12 percent) compared to current rates. While the rate seems incredibly high at the moment, such rates are not unheard of. If you look at the late 1970s and early 1980s, mortgage rates were even higher than 12 percent. So, don’t assume your rate will remain somewhere in the current market range over the life of your loan.

This points out one other item to think about when deciding on an ARM versus fixed rate mortgage. In evaluating the ARM, assume that you will, at some point, be faced with paying the maximum rate and, thus, the maximum monthly payment. If you cannot afford the maximum monthly payment, think twice before going this route.

Purchasing a new home is a big decision. It can be the best decision you will make, but decisions about financing can be tricky. If you are faced with the purchase of a new home and don’t know what your best bet on financing is, take a moment and use some of our financial calculators to see what your best options might be.

Have a great May.


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