Ask the grumpies: Basic mortgage advice

Green hills asks:

I am wondering if you can give your opinion on the best loan types for first time home buyers. Is an adjustable rate better over time than a fixed rate? And what is the difference between the loan interest rate and the APR? We’ve done a bunch of reading and really, have just confused ourselves more.

There are very few instances in which you would want an adjustable rate rather than a fixed rate.  (Leightpf is one of the rare exceptions.)  The very fact you are asking this question means that the best loan for you is a 20% down fixed interest rate, either for 15 years or for 30 years.  Whether you choose 15 vs. 30 will depend on the difference in the interest rates and what you would do if one of you had a job-loss or other emergency.  (30 year loans are safer– you can pre-pay them as if they were 15 year loans and then when an emergency hits, lower your payments, but a 15 year loan can save a lot of money.  You have to look at the numbers to see which is best for your situation.)

In general for loans, the APR includes compounding.  Different loans compound at different times.  APY doesn’t take into account compounding.  For mortgages, APR also includes a bunch of junk that mortgages try to confuse you with like “points” and “rolling fees into the principal” (a quick google search says it doesn’t include the paperwork fees, so you will compare those separately).  The APY is jiggered so that they can make it seem like they’re offering you a low rate but then they hit you with a bunch of upfront fees. You should be comparing APR and ignoring APY when you’re trying to decide between mortgage lenders.  Get the APR in writing.

So:  quick bottom line:  Use APR.  Save at least 20% for a downpayment.  Get a fixed rate mortgage for either 15 or 30 years.  Don’t buy more house than you can afford!

Ok, now for unusual situations that do not apply to you.  If you have a lot of cash and are in no danger of ever defaulting on your mortgage or being unable to make your monthly payments, then you may be interested in an ARM if 1.  The difference in interest rates between the ARM and the fixed rate is high and 2.  There’s no way that you’re going to end up with the rate being reset at the end of the ARM into something that you can’t pay back.  So, if you’re flush enough that you can definitely pay back the mortgage before the rate resets, or the limitations on how high the rate resets that make it so it can’t reset to something you can’t afford, then you may want to consider an ARM.  The argument that people usually make when choosing an ARM is that they’re going to resell the house before the end of the term anyway so it doesn’t matter what the rate resets to– but you have to be sure that you won’t need to short-sell that house or keep it on the market longer than expected (another reason to have cash on  hand to make up the difference if the market drops) and that your plans aren’t going to change.  So be careful.

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20 Responses to “Ask the grumpies: Basic mortgage advice”

  1. Linda Says:

    Buying our first place (a condo) we were told that we were getting an ARM. We had discussed getting a fixed rate mortgage with the mortgage broker, but when we were at the closing table we were presented with a 5 year ARM. Our lawyer advised us that this is pretty common for a condo so not to freak out. It worked out for us as we did sell the condo about three years later. (We had a really bad mortgage broker, obviously. He had come recommended from a work colleague, but that didn’t seem to make a difference.)

    Anyway, it does appear to be true that the type of housing you’re buying could have an impact on the type of mortgage you are offered, too.

    • nicoleandmaggie Says:

      That should be illegal if it isn’t.

      No, you should still be able to get a fixed rate mortgage with a condo. The ARM with a condo comes along with the myth that housing prices will always go up (so you can always sell before the rates re-adjust) and the belief that you won’t be living in a condo longer than 5 years. Condo markets bubble and then crash and burn on a regular basis, making that strategy dangerous.

      • Linda Says:

        Well, it happened about 18 years ago and there’s no way to sue the guy now. It was really crappy of him, though, since we would have lost all our earnest money if we had walked away from closing due to not getting the financing we had thought we were getting. Live and learn, I guess.

      • nicoleandmaggie Says:

        I wonder if you’d made a move to walk away if he would have suddenly discovered the mortgage you’d actually discussed. We had a car salesman try that trick with DH once, and they did suddenly find the car they’d agreed on once he started walking away.

        I guess this is a good time to remind folks to get mortgages pre-approved before you go into closing!

        They have cracked down a lot on this kind of predatory lending since the last mortgage crisis, but it’s still something to be on the lookout for.

      • Contingent Cassandra Says:

        ARMs may currently be the only option for the complex in which I live, but it’s a really unusual situation: a co-op sitting on leased land, with a definite end point to the whole deal (so, technically, one is buying shares, not real estate, though the mortgage interest and real estate tax deductions do apply). I have a 30-year fixed, but I got it several years ago, and we’re now about 40 years out from the point where the land lease expires, so lenders are going to get increasingly cautious (and, I assume, at some point, start either charging higher rates or insisting on shorter terms). I’m not sure all buyers understand all of the ramifications of the situation; I did, and decided it was the best of the very limited options available to me. I know that I’m not really building lasting equity, whatever the mortgage balance and current sales prices may indicate, which is beginning to rankle a bit, and will be the main reason I move on if I do, but my net cost is lower than rent, and it’s fixed.

        So — an ARM might be the only option in some very unusual situations, where only a few banks are wiling to lend at all (partly because they’ll have to keep the loan in-house, because the situation is too odd for it to be salable). But, at least in my experience, everybody was very upfront about what the options were, and there was no confusion between ARMs and fixed-rate loans.

      • nicoleandmaggie Says:

        That sounds very unAmerican! (As in, that kind of thing is more common in other countries.)

      • Contingent Cassandra Says:

        It’s definitely unusual, at least for my area. As far as I know, there are only 2 other co-ops of any sort in the area, both own their land, and one is in the process of selling out to a developer rather than update crumbling infrastructure.

        I figure my own situation is something like owning a not-really-so-mobile manufactured home set on someone else’s land, with the advantage that I know more or less when the property owners will decide to make other use of the land, leaving me to look for another home (the arrangement could end early if the majority of shareholders agree to be bought out, but there’s a complicated co-op structure, and efforts to do that during the last boom failed. Still it’s a possibility I need to be aware of.)

  2. SP Says:

    This is extremely helpful. Is there a “home buying for dummies book” you or any readers can recommend, or where did you find your information when it was all foreign to you? I know the info is out there, but the variety of ways to find it is kind of overwhelming. Information like this about the whole process would be nice – simple clear terms, tells me what to ignore and what to pay attention to, gives practical advice and exceptions to the usual advice.

    • nicoleandmaggie Says:

      Honestly, I think I found my information on the internets back when we first bought… I remember the CNN Money 101 series to be really helpful. Possibly also the motley fool (though we used them more for car buying). But we bought our house a long time ago. I’ve also kept up with the mortgage crisis etc. for professional reasons. I don’t know what’s most useful now.

    • nicoleandmaggie Says:

      http://money.cnn.com/magazines/moneymag/money101/lesson8/index.htm is the money101 page.

      We disagree with #5. (We did that and they redistricted us! We’ve got a post on whether or not to always buy in a good school district in our archives somewhere.)

      Their page isn’t really complete though. There are also a lot of different viewpoints out there about things like PMI etc. My view is definitely colored by knowing people who have made standard mistakes and been stuck with a house they couldn’t sell for the mortgage amount. Given my level of risk-aversion and distaste for defaulting on debt, I tend to recommend safer options (which means only take the riskier option if you can mediate that risk).

      Lately About.com has had reasonably good advice on many topics. I haven’t looked at their mortgage pages though.

    • Debbie M Says:

      I took an informal class at the local university.

    • Rosa Says:

      we took a first time homebuyer’s class through the local neighborhood association (not from a real estate agency! A nonprofit!) It was helpful for stuff like this and also for very specific things like loan programs and fix-it programs in our area, and what other costs (sidewalks! water lines!) we would be responsible for, that are specific to locality.

      • nicoleandmaggie Says:

        The funny thing about these comments is that I have a post in the queue about new research coming out showing that people are willing to go with the most risk averse mortgage possible so long as they don’t have to take a class about mortgages.

      • Rosa Says:

        your readership may be atypical. Given that we’re discussing mortgages for fun in our spare time & all.

        I found the class very comforting. It was mostly not about mortgages, but about stuff like how to estimate future repair costs, how to get your credit rating up if you need to (it was the first time i saw my credit report!), stuff like that.

  3. bogart Says:

    I agree 100% with your advice in the current interest-rate environment (and immediately foreseeable future one). Would it be different in a (much?) higher-rate environment? The first time DH and I financed a house, we went with an ARM; a “good” one (limited variance) through our CU at 7.5%, which was low-to-competitive for that era, and of course lower than fixed. That may not generalize; it was a somewhat unusual situation as we were committed to staying in his existing house (buying his ex-wife out) for the kids, so were arguably taking on more mortgage than we should have (90% LTV), though fortunately history has shown that to have been a fine-to-good decision financially (and a good decision for other reasons, though of course we lack a counter-factual). But when rates are high but reasonably (?) expected to head down over the next decade or so, and contingent obviously on other factors (job stability, etc.) I can see an ARM making more sense.

    We have since refinanced (still live in the same house) several times, and are now in a 30-year fixed at a MUCH lower rate (~4.25).

    • nicoleandmaggie Says:

      It depends on the difference between the ARM rate and the fixed rate AND what you can do to mitigate the risk in an ARM. Does the ARM have a top rate that it can reset with that you can deal with? Is the difference in rates so large that the savings over the ARM could be used in an emergency? What would you do if you had to move and your house had dropped in value? Do you have enough cash to avoid a short-sale or foreclosure? (Or are you willing to foreclose?) Are the situations in which you’d have the worst case scenario such that defaulting on a mortgage is the least of your worries?

      Sometimes you get lucky with ARMs, but it isn’t as good to get lucky as it is to avoid a catastrophe if you get unlucky. So think about the potential upside and more about the potential downside and minimize that downside. We’re really not good at predicting the future as much as many people think they are. Some folks will turn out to have been right, but that’s mainly because they’ve been lucky.

      Essentially, an ARM is fine if you can cover a higher reset rate in the event that housing values drop at the end of the period and you can’t sell. And it may be worth it if the difference in rates is big enough to take on that extra risk.

      • bogart Says:

        Oh right, good points, and not least on the lucky vs. right thing. As we’re still in that house it’s easy to forget that there were distinct paths (not taken) that would have involved selling it (I think those too would have been OK, but that in turn is a function of conditions-in-the-potentially-relevant moments which were, of course, unforeseeable, guesses aside.).

        Looking at our CU’s rates right now, they are 3.25 on the ARM with a ceiling of 6 (and they only reset every 2 years and can only go up 1% each reset) and 4.5 on a 15-year fixed. The CU doesn’t offer longer fixed and although I’d forgotten this, they didn’t actually offer fixed at all when we took out our ARM through them. So it was a weirdly constrained environment (we MUCH prefer the CU to banks and their rates tend to be noticeably better though in this low-rate environment big differences are less attainable, math being what it is) and that, too, surely factored into our decision-making.

  4. Alcie Says:

    The most useful online info I found on things to be aware of when buying a house (especially related to a mortgage) was a guide published by Freddie Mac. The link is here: https://thehomeownerscafe.com/docs/freddie-mac-step-by-step-guide.pdf ; I don’t know if it will go through in a comment. Even though our current house was the third house we have bought, a lot had changed about the process in the last few years so our knowledge from the last house was out of date. Just knowing who all the people involved were was helpful; there appear to have been a bunch of extra administrative layers added to the loan process that we never had to deal with before.

  5. chacha1 Says:

    I’m gonna look at that link even though we almost certainly will not be getting a home loan (now that we are buying property and planning to build). Our experience with the land purchase was that of complete neophytes and much of it was confusing to us. The most-confusing part, though, was that the contracts all have so much irrelevant boilerplate in them. It seems to me that in this day and age, it should be the matter of a few keystrokes to generate a transaction-specific contract. Ours, for example, has text about mandatory fire insurance. Well, it’s not mandatory if the land you’re buying *doesn’t have a house on it*. But the contract certainly doesn’t say that. Le sigh.


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