April 11, 2018

Most house purchasers look at many houses before they make a decision, weighing multiple features of one against the other. In contrast, the decision about which of numerous mortgage options to select often is made hastily with little thought. Yet borrowers have to live with their mortgage indefinitely, often for as long as they have the house.

This article will provide some general observations about the options available in 2018, and indicate how individual borrowers can find the option that is best for them. .

Options in 2018

In one respect, the problem is a little simpler in 2018 than it was before the financial crisis because the riskiest options and loan types are no longer available. These include interest only and negative amortization options, the 40-year term, and adjustable rate mortgages with initial interest rates that hold for very short periods. Some of these options may be available in the sub-prime market or on jumbo loans, which are those too large for purchase by Fannie Mae or Freddie Mac.

Nonetheless, the US remains an outlier in its wide range of options offered borrowers. These include fixed-rate mortgages (FRMs) with terms of 10, 15, 20, 25, and 30 years, and 30-year adjustable-rate mortgages (ARMs) with initial rate periods of 5, 7 and 10 years. Further, most of these options are available on both FHA loans, which are insured by the Government, and conventional loans eligible for purchase by Fannie Mae and Freddie Mac.

General Decision Rule

How should borrowers choose from among these options? They should select the type of mortgage that results in the lowest total cost over the entire period they have the mortgage, subject to the condition that the initial payment is affordable, and the risk of future payment increases is tolerable.  While few borrowers know exactly how long they will have their mortgage, an estimate of the cost based on their best guess of their tenure is far better than basing the decision on the interest rate or the initial monthly payment, which can easily lead a borrower astray.

The Total Cost of a Mortgage

Total cost is the future value of all upfront charges, monthly payments of interest, principal and mortgage insurance, and lost interest on those charges, less tax savings at the borrower’s tax rate, and less reduction in the loan balance.  Calculating this number manually is tedious, but a calculator on my web site makes it easy.

Selections Based on Time Horizon

I recently used my cost calculator to see if I could develop some broad selection guidelines on which borrowers could depend. The first issue I looked at was how the best mortgage type varied with the borrower’s time horizon. The following pattern emerged:

• If borrower has the mortgage 5 years or less, the 5/1 ARM is best

• If borrower has the mortgage 6 or 7 years, the 7/1 ARM is best.

• If borrower has the mortgage 8 to 12 years, the 10/1 ARM is best.

• If borrower has the mortgage more than 12 years, the FRM is best.

In cases where the FRM turns out to be the best, the borrower must then choose between the different terms. The cost saving on the 15-year FRM is particularly sizeable, but it carries a larger monthly payment that the borrower may or may not find affordable.

Further exploration indicated that the pattern described above did not hold for borrowers with credit scores of 620 or less. Only FRMs were available to such borrowers.

Selection Between Conventional and FHA

Borrowers who qualify for both FHA and conventional loans are often presumed to be better off with conventional, but that is not necessarily the case. I found that over any time horizon borrowers had lower costs on FHA if their credit score was 700 or less with a 5% down payment, and 660 or less with a down payment of 10%. In all other cases, the conventional loan had lower costs.

Concluding Comment

General guidance on mortgage type selection is better than no guidance, but the exceptions noted above point to the limitations. There is no substitute for direct access to a cost calculator by the individual borrower. To use mine, borrowers enter the required information about their transaction, and the program calculates total cost over the period they specify for every type of mortgage, at the best mortgage prices posted that day by the lenders who deliver prices to my site. For ARMs, the program also shows the total cost and monthly payment on a worst-case interest rate scenario. In sum, it shows everything the borrower needs to know to make the best choice. You can access my calculator here.