Mortgages traditionally come in a 30-year variety; in fact, the most popular home loan by a big margin is a 30-year fixed mortgage. However, a 30-year mortgage isn’t your only option; mortgages also come in a 15-year variety, typically with a significantly higher payment. When should you choose 15, and when should you take 30?
Benefits of 30-year mortgages
30-year mortgages are the most popular home loans for a reason: the payment is lower. A 30-year mortgage generally has a 25% lower payment than a 15-year mortgage. This is valuable for a lot of reasons; it frees up income for other household expenses, and helps homeowners keep their heads above water if an unforeseen financial situation should arise.
A 30-year mortgage is also beneficial because homeowners can use some of that money they save by contributing it to an IRA, 401k or other retirement account; thus meeting long-term goals while simultaneously maintaining a mortgage. Finally, you simply don’t want to live cash-strapped from month-to-month for 15 years to take on a shorter mortgage, so a 30-year mortgage can give you financial flexibility that you might otherwise lack.
When to consider a 15-year mortgage
The primary benefit that a 15-year mortgage offers is that you pay less in the long run for your home. With fewer mortgage payments, you pay less in interest over the course of your loan. That means you can buy your home cheaper over 15 years. A 15-year mortgage can also be beneficial if you have goals you want to meet by freeing yourself from mortgage payments in 15 years. For example, if you have a young child, you might want to plan to be paying for college 15 years down the line, so a 15-year mortgage can be the perfect choice.
Finally, if you make enough money that you contribute the maximum to your IRA and 401k and still have cash leftover, a 15-year mortgage is a great forced savings plan, and a good way to make your money work for you. However, you should make sure you’re meeting your other financial goals before you consider a 15-year mortgage.
Does APR Tell the Whole Story?
Did you know that every time a mortgage broker or lender quotes you an interest rate, they are also required to quote the APR?
Basically, Annual Percentage Rate (APR) is a tool to compare and understand interest rate offers when borrowers are shopping for a home loan. Essentially, the federal home lending guidelines say that certain closing costs associated with obtaining a residential mortgage loan, need to be expressed as an interest rate (APR equals contract rate plus these additional costs). Loosely, the costs that should be included in an APR calculation are the closing costs associated with obtaining a mortgage loan that would not be incurred if you purchased with cash. The APR is intended to allow “Apples-to-Apples” comparisons of multiple quotes from various mortgage brokers or lenders.
The following discussion assumes a Fixed Rate Mortgage loan. Adjustable Rate Mortgages (ARM’s) are a discussion for another day.
Closing Costs Included in APR Calculation
Some of the residential closing costs that should be included in the APR calculation of a mortgage loan are Loan Origination Fees (Points), Prepaid Interest (can be manipulated), fees charged by a lender such as Underwriting Fees, Admin Fees, etc.
Closing Costs and Fees Excluded from the APR Calculation
- Attorney’s Fees
- Recording Fees at the Registry of Deeds
- Doc Prep Fees for preparing mortgage loan documents and other settlement documents
- Fees for title insurance, title exams, and plot surveys
- Notary fees
- Appraisal fees
- Credit report fees
- Fees for escrows of taxes and insurance
What this means is, if two lenders each have $3,500 in closing cost fees and one lender categorizes more fees as excludable in the APR calculation than the other lender, then that APR will be lower. This would imply that the lender with the lower APR is actually offering a better deal, but that is not the case. All they are doing is categorizing their fees in a way that allows more of their closing fees to avoid being included in the APR calculation. For example, categorizing all legal services performed as “Doc Prep” or “Title exam” would now exclude these fees from an APR calculation whereas an “Attorney Fee” would have to be included in the APR calculation.
Here is the takeaway
Not all closing cost items are considered a “fee” for an APR calculation. A borrower pays these “fees” regardless of whether they are included in the APR or not. What should you do about this? It is recommended that you do your own thorough “Apples-to-Apples” comparison. At each Interest Rate add up the dollar amount of the Points and all other costs on a line-by-line basis. Prepaid Interest (which can be manipulated at the quoting stage), will be the same at all mortgage brokers or lenders once you close, should be ignored for this cost analysis. If the rate of 4% carries points and all other costs of $4,000, this is a better deal than a rate of 4% with $4,500 in points and all other closing costs. The tricky part comes when a mortgage lender will not compare “Apples-to-Apples” for you. So if the rate is 3.875% with $4,500 in closing costs or a rate of 4% with $4,000 in closings costs, which is the better deal? This is where the APR should help; assuming mortgage brokers or lenders are using the same guidelines in their calculations.
Make sure to get all of these detailed quotes in writing and ask if you can lock-in!