When purchasing a home, one of the most confusing aspects of the process is selecting a loan. There are many different financial products to choose from, each of which has advantages and disadvantages. The most popular mortgage product is the 30-year fixed rate mortgage. This article discusses how the 30-year compares to other mortgage products, benefits of the 30-year, and fess to avoid when selecting a 30-year mortgage.
Comparison to Other Mortgage Rates
When selecting a mortgage, there are many different mortgage products and terms to choose from, each of which has different interest rates. While 30-year fixed rates are near an all-time low, and were recently below 5%, they are still higher than other options. 30-year rates can be compared to the following popular products:
- 15-year Fixed Rates – 15-year fixed rates are normally lower than a 30-year and, depending on the lender, the interest rate variance ranges from 0.50% to 0.75%. These rates are often lower because having a shorter term provides significantly less risk to the lender. Although interest rates are lower, 15-year payments are higher than 30-year payments because the loan has to be paid off in half the time.
- Adjustable Rate Mortgage (ARM) – An ARM often comes with interest rates well below those of a 30-year. With an ARM, a borrower receives a very low fixed interest rate for a period of time, which normally ranges form 1 to 7 years, before the rate adjusts to a higher level. Normally, the shorter the initial low interest period is, the lower the interest rate is. The most common ARM product is the 5-year Adjustable Rate Mortgage, which commonly comes with an interest rate 1% less than a 30-year.
- Interest Only Mortgages – While they are not as frequently offered today as in years past, many borrowers still opt for interest only mortgages. Since interest only loans do not require principal payment and do not amortize, the balance due never decreases. Because of this, lenders assume a lot more risk and often require a sizable down payment and charge higher interest rates. Interest only mortgage rates are commonly 1% higher than 30-year rates.
The Best Time to Get a 30-year Mortgage
The best time to get a 30-year mortgage is when interest rates are low. Interest rates tend to fluctuate quite a bit over time. Recently average 30-year rates were below 5%, but in the past few years have been well above 6%. Rates depend on various economic factors, including the following:
- Supply and Demand – Like all other items in our economy, supply and demand have a significant impact on rates. If many people are looking to purchase a home or refinance, rates tend to go up because of the excess demand. If interest rates are high and fewer people want to refinance or buy a home, demand is low and the rates will fall.
- Inflation – Inflation also has a large impact on rates. As an economy improves, inflation will naturally set it. To slow inflation, the federal government will be required to raise interest rates. If an economy is worsening and inflation subsides, the federal government will then reduce interest rates. While raising or lowering the Federal Funds Rate does not have a direct impact on mortgage rates, mortgage rates tend to follow the federal rates over time, and typically are a bit higher than the rate on the 10 year treasury notes. While most mortgages have a 30-year term, most people tend to move or refinance roughly every 5 to 7 years, which is why the loans are indexed against the yield on 10-year treasury notes.
Benefits of Selecting a 30-year Mortgage
Selecting a 30-year over other options comes with many benefits. Some of the benefits are:
- Fixed Payment – The first benefit of selecting a 30-year fixed mortgage is that it comes with a fixed payment. Many borrowers in the past few years have been enticed to select an ARM which offers a very low initial interest rate. Once these ARMs adjust, many homeowners have found themselves in trouble because they didn’t realize how high their payment would be, and the new adjusted payment was unaffordable. With a 30-year, you know exactly what your required payment will be over the course of the loan.
- Build Equity – Another advantage of selecting a 30-year is it allows a homeowner to build equity. Each month, a portion of the payment goes towards paying down the loan, which in turn builds a homeowner’s household equity. Other products, such as interest only loans, do not allow a homeowner to build equity.
- Increased Cash Flow – Another benefit of selecting a 30-year is that it increases your cash flow. While a 15-year comes with a lower interest rate, the payments are often 40% higher than a 30-year. By selecting a 30-year, a borrower could save hundreds of dollar each month which could be spent saved, invested, or spent elsewhere.
Costs to be Aware of
While there are many benefits of selecting a 30-year, many lenders attempt to lump additional costs of fees into the mortgage. Some of the most common costs or fees that should be avoided are as follows:
- Points – The most common fee that often comes with 30-year are mortgage points. A point is a fee which is either lumped into the loan balance or paid by the borrower at closing. A lender often uses points to pay down the 30-year interest rate to a lower level, which entices a borrower. Generally speaking, each point, which costs 1% of the loan balance, and pays down the interest rate by 0.125%. to 0.25%. Depending on the loan, a mortgage borrower may recoup the point fees after 3 to 5 years, though in some cases it can take significantly longer. If the homeowner sells the home before reaching the break even point then they lost money buying points.
- Balloon Payments – In some situations a lender may offer a 30-year mortgage, with a 15-year balloon payment. In this situation, the borrower would be required to either payoff the outstanding loan or refinance the loan after the 15th loan year. The borrower should avoid this stipulation, because in most situations they will not have the liquidity to make the balloon payment.
- Pre-Payment Penalty – Some lenders charge a pre-payment penalty to their borrowers. This penalty will charge a borrower a fee equal to a fixed percentage of the loan balance if they attempt to payoff the loan early. This fee normally phases out after 3 years, but can be as high as 2% of the balance. These fees are more commonly included in bad credit mortgages.