If you have reached a point in your home-buying journey where you have multiple mortgage options, congratulations! The end of your quest is near. You will then start on another, longer journey – paying off your mortgage.
How do you decide which mortgage offer is best for your situation? The first step is to make sure you realistically assess your current situation, and predict the future as best you can. Consider the following factors:
- Job/Income Stability – Do you have a stable job with predictable income? Is your job or your advancement plans likely to require moving to different cities?
- Financial Situation – You can check your credit score and read your credit report for free within minutes using MoneyTips' Credit Manager. Then, ask yourself if you are already stretched thin with your loan payments and other debts? Do you have the upfront money to increase your down payment or pay points to lower your interest rate? Do you have large, upcoming, time-predictable debts like college educations for your children?
- Refinancing Plans – Do you intend to refinance after a certain amount of time to get a better deal on interest rates in the future?
- Family Plans – Do you intend to have a family (or increase your current one), and will that require a larger house? Or will you be going in the other direction and downsizing an empty nest before long?
The common thread here is predicting how long you are likely to stay in the house, and whether your future debt and cash situation will be better, worse, or the same in the short- to medium-term future. That is important because time, cash, and future plans affect your decision.
Comparing loans head-to-head can be difficult because both upfront costs and running costs differ from loan to loan, but the Annual Percentage Rate (APR) is generally the best for direct comparison. The APR takes other costs into account, including closing costs, fees and PMI (Private Mortgage Insurance) as well as the interest, and converts them all into present-day dollars. This allows for direct comparison of all costs over the entire term of the loan. If you keep your house for the full loan term, APR is the clear-cut best comparison.
However, you do have to make sure that different lenders are including the same costs in their APR calculations. Combining the APR with the lender's good-faith estimate of costs on the same type of loan and interest rate can help clarify any hidden costs that one lender includes in an APR but the other one hides.
If you expect to sell or refinance relatively early in the loan term, the APR is less useful. It cannot tell you if you have reached the point where the benefit of a lower interest rate has surpassed the higher upfront costs.
In that case, you will need to compare the nominal interest rate and upfront costs separately. Calculators are available online to help you determine the better deal by running different scenarios on when you may have to sell or refinance.
The cash situation and expected occupancy time of the house also will determine which type of mortgage is best for you – fixed-rate, ARM (Adjustable Rate Mortgage), or a hybrid of the two.
Fixed-rate loans offer stability and predictability in payments, for the tradeoff of a higher interest rate; ARMs offer lower initial rates with the tradeoff of uncertainty in the future rates. Hybrids blend the two approaches, with an initial fixed rate period (often 3-5 years), followed by annual adjustments through the rest of the loan term.
If you do not plan to stay in your home for a long time and/or need to minimize your payments, an ARM or hybrid is probably the best choice for you. You can sell or refinance when the changes in interest rate provide the best opportunity. If you are fortunate, you can refinance at a fixed rate before rates rise significantly.
Conversely, if you plan to stay in your house for a longer period and/or you can afford higher monthly payments, a fixed-rate will likely save you money in the long-term over a hybrid or an ARM.
Check online resources for the interest rate trends over the last year and the expectations of forecasters on interest rates for the next year. With all other things equal, a low interest rate favors a fixed-rate mortgage (because interest rates are more likely to rise), and a high interest rate favors the savings of an ARM (because interest rates are more likely to stay stable or drop). However, the trend is just as important as the current value.
Comparing fixed-rate and variable or hybrid loans can be difficult as well, because you cannot truly predict how the interest rate will vary over time. However, there are specialized calculators available online that can allow you to run different fixed vs. variable rate scenarios and head-to-head comparisons to construct your own "what-if" graph.
With respect to your cash flow and debt, you need to consider whether you have enough money for upfront payments – and if you do, whether or not that is the best use of your money. For example: paying upfront points to buy down your interest rate makes no sense if you can't pay other short-term bills, or if you are likely to refinance before your savings in lower interest rates pays off the upfront costs.
In summary, a large part of what determines the best mortgage for you depends on your assessment of how long you expect to stay in the house, and your cash/debt situation – both short and longer term.