Thursday, May 10, 2007

How the Right Mortgage Loan Helps You Build Wealth

One of the basic principles of personal finance is to keep things simple and understandable. Simplicity allows you to understand where your risks are, and to figure out how to deal with them effectively. Complicating your personal finances forces you to drive on foggy roads, and you may not see every obstacle in time to avoid it.

The most recent illustration of this point is in the real estate markets. Many homeowners are struggling to meet payments on interest only mortgages, adjustable rate mortgages and option ARMs. Foreclosure rates are increasing. And, with real estate values sluggish or dropping in many major markets, your ability to refinance out of a bad loan is limited or nonexistent.

Interest only mortgages and option ARMs seem like great loans at first. You need to make only modest monthly payments, and it's easy to qualify for a nicer house than you thought you could buy. However, it's important to understand that these loans allow you to delay repayment--but not indefinitely. An interest only loan lets you pay only the interest on the loan for a short time, such as a year or two or three. Then you will have to start paying the principal of the loan. Your monthly payment will jump, and by quite a bit.

The option ARM allows you not only to delay repaying the principal of the loan at first, but also to delay payment of some of the interest. But the unpaid interest is added to the principal of the loan, effectively increasing the amount of the debt. The monthly payments in options ARMs tend to increase sooner rather than later (sometimes within months). With the addition of unpaid interest to the principal, the increase in monthly payments could be seriously painful.

Adjustable rate loans begin with an interest rate that will be effective for a year, or a few years. Then the loan rate will change as interest rates in the financial markets change. But the change is likely only to go upwards. Adjustable rate loans tend not to decrease the rate (you usually have to refinance to get a lower rate). You could see a big jump in payments if interest rates rise significantly.

The common thread among all these loans is that they are complicated and often unpredictable. You can't effectively budget or plan for your long term financial well-being if you don't know what your mortgage payment will be in a year or two. Things only get worse if you can't afford the increased payment. You may be unable to buy the new car you need, and will have to hope the brakes and tires on your old car last a while longer. Money you wanted to save for your golden years or your child's college expenses may be devoted to the greater profitability of your mortgage lender.

So, what to do? Use a traditional fixed rate mortgage. This loan locks in your housing costs. You know how much you'll have to pay each month of the loan. There will be no surprises. Once the loan payment is fixed, you can budget around it and allocate money for savings. Look back at the World War II generation. Before the war, mortgages tended to be for a short duration (like 5 years) and require substantial downpayments (like 50%). When the GIs returned from the war, the 30-year fixed rate mortgage came into common usage. The housing market boomed and home ownership rates rose. With fixed housing costs, the members of this generation could and did build wealth perhaps like no generation before them. They were often able to fully pay for their homes and save money beyond that.

Yes, initially the cost of a fixed rate mortgage is higher, with a larger monthly payment. But no one can predict the direction of interest rates. A loan with an adjustable rate, or which you have to refinance in a few years because you can't afford the payment increases, may cost you more over the long term than a fixed rate mortgage. Further, incomes tend to rise over time, so your income will probably increase while a fixed rate mortgage's monthly payment does not. The extra money can enhance your lifestyle and increase your retirement portfolio. People earning $5,000 a year in 1955 might have had a mortgage payment of about $150 a month (seriously, many mortgage payments were this low). By 1975, they might have been earning $15,000 or $20,000 a year; but their mortgage payment was still $150 a month. That's a good situation to be in.

Fixed rate mortgages may not initially be as easy to get or pay as other, more complex loans. But most things in life worth doing or having don't come easily. The fixed rate loan ultimately makes your life simpler and easier. That will be conducive to your financial well-being. Even if you have to buy less house, you'll have more peace of mind.

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