When it comes to making the largest purchase of their lives, most homebuyers would prefer to play it safe in choosing a loan.
That’s why fixed-rate mortgages, the gold standard of home loans, have long been the most popular. These 15-, 20-, and 30-year mortgages aren’t exciting. But what they lack in style, they make up for in stability.
Borrowers can lock in the amount of their monthly mortgage payments (minus taxes, insurance, and homeowners association fees) for the duration of their loans. Then they can sleep soundly knowing their housing bills won’t just shoot up at some future date. They’re all set.
However, with the troubling combo of high mortgage interest rates and expensive home prices, many first-time and other buyers are learning they can no longer afford to become homeowners with a fixed-rate mortgage. So they’re looking into other options. And there are plenty out there: adjustable-rate mortgages, interest-only mortgages, 2-1 buydowns.
Some of these loans and programs start off with a few years of cheaper monthly mortgage payments, which can help cash-strapped buyers become homeowners. But borrowers should proceed with caution—and fully understand the fine print. The monthly payments on these loans typically rise, sometimes substantially, over time.
If mortgage rates fall, borrowers can refinance into new loans with lower monthly payments. But if rates stay elevated, or worse, rise, buyers could be saddled with higher payments that may be tough to afford.
Those still scarred from the Great Recession will remember watching in horror as millions of homeowners lost their properties to foreclosures and short sales after their mortgage payments suddenly spiked. Those bad mortgages set off the years-long, global downturn—making the boring, fixed-rate mortgages look pretty good.
These days, though, those predatory, subprime mortgages have largely been eliminated. Many loans have caps on how high a borrower’s future payments can rise. And if mortgage interest rates fall, as expected over the next few years, borrowers could wind up saving money by choosing one of these loans.
So what do today’s homebuyers need to know when choosing a mortgage?
Shop around for a mortgage
Shop around for a mortgage! Your persistence could save you thousands of dollars a year. There are fewer buyers out there hunting for homes because they can’t afford the higher mortgage rates. So lenders are hurting for business. That can work to your advantage.
Mortgage rates and fees can vary quite a bit from lender to lender, and lenders may be more willing to compete for your business. So play them against one another. If you have a strong credit score, are putting down a large payment, or are a customer of the bank, ask for a lower rate or for fees to be waived. Then see if you can find a better deal elsewhere.
Many lenders will match what their competition is offering, which is what happened when I bought my house last year. So if you would prefer to go with one lender, but get a better deal elsewhere, see if the lender can match it.
Adjustable-rate mortgages are waging a comeback
Adjustable-rate mortgages, or ARMs, have gotten a bit of a bad rap over the years as the interest rates on the loans are constantly changing. However, borrowers on tight budgets can save some money with these loans—at least initially.
The most common is the 5/1 ARM, although borrowers can also choose a seven- or 10-year ARM. You typically receive a lower mortgage rate for the initial years of the loan, making ARMs popular right now because of higher rates. For a 5/1 ARM, the mortgage rate is fixed for the first five years, then it adjusts annually to the current rates.
It’s a risk that makes it difficult to calculate your future expenses. If the rate is higher, then a borrower’s monthly housing payments will increase for that year until rates readjust. That could really stretch a budget very unexpectedly. If rates are lower, though, then your payment can go down and you could wind up saving money.
You could wind up getting a great deal or get financially screwed—depending on which direction mortgage rates move.
The good news is there are generally caps placed on how much higher rates can be in a year and how much higher they can go during the life of the loan.
You can also refinance into a 30-year fixed-rate loan, which may be appealing if rates fall. The catch: Refinancing isn’t free. You typically pay between 2% and 6% of the loan amount, which generally totals thousands of dollars.
More buyers are exploring interest-only loans
Interest-only loans have also been gaining in popularity as buyers look for ways to save money. For the first three, five, or 10 years of a typical interest-only loan, borrowers pay only—you guessed it—the interest on the loan. Then they spend the next 20 or even 30 years paying off the balance of the loan, which is structured as an ARM.
Since you’re paying only interest in the beginning, the mortgage rates tend to be high, while the monthly payments are usually lower. However, once the interest-only period ends, the monthly payment usually rises significantly and can even double or more.
These loans are generally best for the uber-wealthy who are buying $20 million homes, investors who plan to flip the property, or doctors and other professionals who may not have a large down payment but fully expect their income to rise. They’re rarely used by everyday buyers who plan to live primarily in these residences.
The mortgage rates on these loans are generally high, making it harder for many borrowers to qualify for these loans. They often require higher down payments. And since you’re paying only interest for the first decade, you aren’t building up equity in the home unless it appreciates. So if home values fall, you could find yourself underwater on your mortgage.
Buy mortgage points to lower your rate
Homebuyers who would prefer to stick with a fixed-rate mortgage can lower their mortgage rate by buying points. It’s not cheap, but those who have the cash can often save themselves thousands of dollars over the life of their loans.
Borrowers can usually purchase points in 0.25% increments, which generally cost about 1% of the full mortgage amount. That means you’ll typically pay $4,000 on a $400,000 mortgage to bring down your rate by 0.25%.
Before you splurge on points, think about how long you plan to stay in your home. If you plan to age in place in the home and have the extra cash, it might be a good option. If you don’t expect to be there long, it may not make financial sense.
Have the seller or builder buy down your rate
Just a few months ago, buyers were waiving inspections and promising to name their firstborn after sellers to get a house. These days, more buyers are asking their sellers and builders to buy down their rates—and they’re getting it.
The most popular is the 2-1 buydown, which temporarily lowers a borrower’s mortgage rate. In the first year, your mortgage rate is 2 percentage points lower than the current rate, in the second year it is 1 percentage point lower. Then it resets to whatever the rate was when you took out the loan.
Translation: If rates are currently 6.5%, then you would have a 4.5% rate in your first year, a 5.5% in your second year, and a 6.5% for the rest of your loan.
Many sellers and builders are eager to close the deal, and they don’t want to drop their prices. So they’re willing to buy down your rate. Just make sure that you can afford your monthly mortgage payments once the buydown period ends.
Consider a VA loan
If you’re eligible for a U.S. Department of Veterans Affairs loan, this may be the cheapest mortgage you can find. The fixed- or adjustable-rate loans don’t require a down payment or private mortgage insurance. They also typically offer cheaper closing costs and lower mortgage rates than fixed-rate and other loans.
The catch is these mortgages are available only to veterans, active-duty military members, and their surviving spouses.