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How To Choose Between The 3 Most Common Mortgage Options
Unless you are a real estate investor, the choice of which source of funding to finance the property purchase will usually be a typical mortgage from a bank or lender.
This is without considering the various government-supported initiatives that lend to borrowers in unique situations.
Without beating about the bush, there are typically 3 mortgage options for the regular home buyer to choose from:
- Fixed rate
- Adjustable rate (ARM)
- Hybrid loan
A fixed rate loan is self-explainable. It is a loan with a permanent interest rate that is fixed throughout the term of the loan… even if it is a 30 year home loan. Since the interest is fixed at a constant, the mortgage payments will be the same as well throughout the period of the loan.
An adjustable rate mortgage is a housing loan with a variable interest rate that fluctuates with financial indicators determined by the lender. The frequency of these fluctuations can be on a monthly basis or even up to 12 months. The LIBOR is a common variable used in these interest rate structures.
A hybrid loan offers more flexibility to the borrower. It is a combination of a fixed rate and ARM. For example, it might provide fixed rate for 3 years and convert to an ARM from the fourth year onwards. To protect themselves from exploitation, lenders usually require a lock-in period during the duration of the fixed rate period.
There are of course, a few more variations of mortgages available in the market.
But typically, a regular home buyer or average homeowner would narrow the choices down to the three indicated above.
Choosing a suitable mortgage
It would be an easy task in selecting a suitable loan if the decision process is only about getting the lowest interest rates.
But borrowing is never that straight forward with financial institutions.
There are other factors at play that a borrower has to put serious consideration into.
Yet ultimately, it comes down to 2 factors:
- Risk profile
- Period of time
Let’s discuss a little more about these two aspects.
In the investment world, it is generally accepted that the higher the risks, the higher the returns.
This holds true that the higher your tolerance of risks, the better your chances of getting a lower interest rate.
ARMs for example, are for borrowers who are willing to take risks.
Because ARMs are pegged to the performance of the market and the economy in general, how well the economy does will impact the amount of interest that the borrower would have to pay.
If for example, a mortgage is tied to time deposit rates, and consumer deposit interest rates rise, the interest rate on the loan will rise accordingly.
The problem is that while economic performance indicators can tell a story of how the market would unfold in the near future, there is little certainty in predictions actually happening.
Therefore, if a borrower believes in his own ability to forecast a market, and determines that the market would underperform, signing up for an ARM would position him nicely to take advantage of lower interest rates when the market tanks.
The risk is if the market actually grows.
For people who are risk-adverse, fixed rate mortgages will allow them to remove the roller-coaster ride of fluctuating interest rates altogether.
Reading the newspapers and watching the news can be a nervy affair for those on ARMs. One can totally eliminate these headaches by taking up fixed rate home loans.
This allows borrowers to remove this financial issue from their minds. And even plan their personal finances very far ahead into the future since they KNOW exactly what they would have to pay recurringly for the house.
However in certain circumstances, a hybrid loan will absolutely make the most sense. Especially when holding period is taken into consideration.
This is when we move into the second factor.
Period of time
If the real estate you are going to acquire is purely an investment play with a time horizon of between 1 to 5 years, a hybrid mortgage would often play nicely into your hands.
This is because it allows you to enjoy a lower fixed rate during the initial years of the loan when you are holding onto the property. And then converts to an ARM when your exit strategy comes around the corner.
By being in an ARM when it’s time for exit, you could very well be subject to little penalty fees, or if any at all.
This helps the borrower to have stability during the initial years of holding and more flexibility when the exit arrives.
If the investor is on a fixed rate loan, he could incur hefty redemption penalties. And if he is on an ARM, he would be running the risk of interest rates getting out of hand.
Saying this, if you are a home buyer and do not see yourself selling the house anytime soon, a fixed rate loan would offer the most stability and predictability. Something that can be critical in household budgeting.
Yet if you can tell that the market would be going down, ARM would put you in an advantageous position to exploit low interest rates.
And if interest rates do rise, there is always the option refinancing… albeit with extra costs to pay.
Finally, if you are trading up, be mindful that you could very well be taking on a bigger mortgage this time.
This means that if you are on an adjustable rate, any movement in mortgage rates can make a major impact when converted to real dollars.