I love working with first time home buyers! These are the lovely folks whose first purchase has a huge impact on their life. The big change comes in moving away from paying someone else’s mortgage every month via rent and towards building equity and financial stability via paying down their own mortgage, participating in market increases, and building good credit with on-time mortgage payments.
However, this first huge leap of faith in buying your own home may be daunting in general, some misinformation and perpetuated myths floating around sometimes make it more terrifying than it has to be. I have heard them all, but a few are common. Today we will discuss the myth of losing your home when your payments go up.
Read on to dispell this common myth I see with my first-time home buyers.
The Myth: I will lose my home because the interest will go up
A common thread I see is the fear of losing the home you worked so hard for. A lot of times, the myth that perpetuates this fear is that of the mortgage’s interest going up. Essentially, I have had clients who say they are terrified that the payments will go up and be outside of their control, thereby forcing them to sell, foreclose, or otherwise abandon their home.
I will describe how this myth originated a bit later in this post. Here is my simple solution to this fear of increasing payments – lets put you into a 30-year fixed mortgage!
The Solution: 30-year fixed mortgage
A 30-year fixed mortgage is your standard loan product that among other great features has one main thing that makes those risk-averse borrowers breath a sigh of relief – your payment amount of principal and interest are fixed for 30 years and they will never go up. The loan document (loan note, the official legally obligating contract you sign for your mortgage) clearly states that your mortgage will be:
- Fixed for 30 years – payments never change
- The loan is fully amortizing, meaning once you pay your 360th payment, your full loan amount will be paid off, no balloon (final payment) will remain and you will get a clear title with your complete ownership to your house
Your real estate taxes and insurance may go up with annual or market increases and inflation, this may increase the amount required to be paid in with your principal and interest into your bank monthly. The bank holds the escrowed monthly payments on your behalf and makes the appropriate semi-annual or annual payments to your real estate tax authority (county) and your insurance company. So the total payment may increase, but it will not be as a result of changes to your principal and interest.
Now onto the mortgage product that likely created this fear or myth in the first place!
ARM – Adjustable Rate Mortgage
There are multiple types of mortgages out there – conventional, jumbo, ARMs, reverse (HECM), and a multitude of other highly specialized programs. When someone says “my rate will go up”, they likely are thinking about the Adjustable Rate Mortgage (ARM). An ARM is a type of mortgage that is fixed at a lower introductory rate for a number of years and then the interest rate on this product adjusts to index (market product tied to a general index, such as LIBOR, plus a margin to arrive at the adjusted interest rate every adjustment period, usually one year).
An ARM is a great tool, but like every tool, it only works if used correctly. ARMs are great for people who want a temporary lower rate and have an exit strategy for when the adjustment period begins. For example, a 5/1 ARM will have a low introductory rate for the first 5 years, and then will “jump up” to the adjusted rate (your Index plus your margin, set forth in the loan documents) every year on the anniversary of your note. If you are only planning to live in this home for a very limited time, such as during a work assignment outside of your desired location, or while you are in school, or during a very limited event in your life, then with a proper exit strategy and ARM can be a great program for you to use! Your strategy to cope with a higher adjusted rate may be that of refinancing, selling your home and paying off the loan with the proceeds, or accepting a risk that your payment may go up above your means or any future potential rent if you do convert this particular property into a rental.
Your strategy to cope with a higher adjusted rate after the introductory period may be that of refinancing, selling your home and paying off the loan with the proceeds, or accepting a risk that your payment may go up above your means or any future potential rent if you do convert this particular property into a rental.
For the above strategies to be successful, you would have to ensure that you have the income to qualify on at the time of potential move (for your new residence) or enough income and cash saved to refinance, as well as low debt outside of the mortgage to make sure you can still qualify for a good program. Some events that can derail a refi or a new purchase may be a decision to retire (thereby limiting your income sources), accident or health challenges that force you to work or earn less, high debt (be it educational loans, auto loans, or credit card debt), or any other event that decreases your income or increases your debts. Another limiting factor may be cash available at the time of potential refinance, as some programs require reserves (money left in your account at the time of close to mitigate the risk of falling behind on payments).
If moving out and selling is your exit strategy, will you be able to move while also selling the home for a high enough price to cover your expenses and your original purchase price? Will you want or be able to move and live else where, while keeping your job or career? Will you still want to move after a few years if your work, family or friendships have organically concentrated around your new location? If you want to sell the home, do you have a plan in place to be able to buy your next property?
If your exit strategy is converting your residence to a rental upon move out – you have to consider the projected potential rents on your property, repairs and other expenses required at move out, your ability and willingness to manage and rent the property, or willingness to hire a qualified property manager to operate the rental. The rent would have to be at least enough to cover the new adjusted mortgage payment going forward and other direct expenses, or at least have a net loss monthly that is acceptable to you and your budget. This net loss or net income will also factor into your new property’s mortgage qualification and may result in higher cash reserve requirements on your new loan.
The Myth dispelled
Since I don’t own a working crystal ball and I can’t predict the many factors that go into deciding that ARM is a great idea for you, I usually recommend that ARMs be used only in perfect-fit situations. One example comes to mind for a person moving into the area for a limited and defined project for their job that was supposed to run for 3 years. They didn’t want to rent for that long and wanted to benefit from any potential market increases during their time in California. They were committed to moving back to their desired location and selling the California residence before the 5/1 ARM’s adjustment period kicked in. As a result of this program, they were able to borrow at an extremely low rate, and market increases in the area yielded a sizable equity increase to this family upon the sale of the property. Their move back was carefully planned and executed. ARM introductory low rate kept their cost of borrowing money low and was the perfect fit to their short-term and long-term financial goals.
An ARM is a great tool when used properly! But if fixed payment is your goal, I will work on placing you into a 30-year fixed program. I never recommend an ARM to someone who is not in a perfect-fit situation for it. I am happy to explain the features and run through the math on any program, but my recommendation for the bulk of my loans is a 30-year fixed program because it is the lowest risk and is often the best fit program for your short-term and long-term goals.
Hope this helps bring some peace of mind to those just starting the journey to home ownership. If you have a question you’d like asnwered about mortgages, financing or taxes, feel free to email or call any time. My contact information is here.
Please call if you would like to get started on your mortgage application – I am available at all hours of the day, including nights and weekends. Call direct at 818-512-9926, or email email@example.com.