Multiple Home Loan Choices: Weapons of Mass Destruction or Tools to Save Money?

Some encouraging signs are emerging in the U.S. housing market: there are significantly more loan choices available today than anytime in the last two to three years. While it is way premature to say that the mortgage market is in a perfect shape, the above is a positive sign of a new trend starting to take root. For one thing, when it comes to home financing, the more choices and the better chance that the loan product will be optimized to end users’ needs, and that is a good thing. Why? Short answer: because it can save borrowers thousands of dollars on interest, improve affordability, and reduce the overall rate of loan defaults.

At the depth of this latest Great Recession, it seemed that the only loan programs available to purchase or refinance residential properties were standard “bread-and-butter” 15 or 30-year fixed mortgages. These types of home loans were proclaimed the “safest” and the best way to go for those who dared to obtain a mortgage loan at all. All the other “exotic” loan products, such as Adjustable-Rate-Mortgages (ARMs), Option ARMs, or Intermediate ARMs (30-year mortgages with interest rates fixed for 3, 5, 7, or 10 years) were declared “weapons of mass destruction,” invented by Wall Street’s “fat cats” and sold by shady mortgage brokers.

With mortgages interest rates at historically low levels, how can anybody go wrong with a long-term fixed rate loan? Isn’t that the best and safest way to go? Not necessarily. The “one size fits all” model did not work very well in the old Soviet Union and it does not work well in the mortgage world either. The problem with offering only long-term fixed mortgages is that not all borrowers have long-term home or mortgage ownership plans.

In fact, according to the National Association of Realtors, the average length of home ownership in the U.S. is only about 6-8 years. It is still less in transient states such as California, Nevada, or Florida. But that is not all. The average life of a loan is also shorter due to a possibility of refinancing. So what? The problem is that the longer the fixed term of the loan, the higher the interest rate. For example, the interest rate on a 30-year mortgage fixed loan is about 1.00% – 1.25% above the rate on a seven-year fixed loan.

For example, in 2010, the average home loan amount, for purchase or refinance, in San Diego, CA was around $400,000. The difference in the interest rate of 1.125% means $4,500 per year. If the borrower can reasonably anticipate that he/she will keep the property for let’s say five to seven years, there is really no good reason to get a 30-year fixed mortgage. It is an overkill. Understandably, nobody has a crystal ball to know the exact length of homeownership a few years in advance. That is why it is recommended to add some extra fixed term to your loan for security, especially if you do not trust ARM loans, but it does not need to be 30 years!

For instance, if one estimates that he/she will keep the house for five years, the seven-year fixed might be sufficient. By the same token, if one thinks that he/she will move in seven years, loan fixed for 10 years should do the job. The bottom line is simple: the more optimized the fixed term of your loan, the more money you will save in interest. And this is real money, which will stay in your pocket, no some imaginary savings.

However, borrowers are not the only beneficiaries of such mortgage loan “precision shot.” Lenders can also benefit from this scenario because lower interest rates mean lower monthly payments, which in turn translate into better affordability and lower default rates. In spite of some public misconceptions, lenders do not make more money on the Intermediate ARMs as compared to the Fixed Rate Mortgages. Quite to the contrary. Historically speaking, long-term fixed mortgages have been the most profitable for the lenders because these loans generate higher yield based 30-year term, yet they are very seldom kept for the entire term.

In conclusion, more home loan products are becoming available to homebuyers and homeowners, who now have a better chance of selecting their mortgage financing to match their individual home buying or refinancing needs. Borrowers should ask their mortgage professionals about availability of different loan programs and request a detailed explanation of their pros and cons. “One mortgage hat” does not fit all, borrowers should optimize the term of their mortgages according to their individual financial needs and homeownership plans.