Buying a house is something I think many people rush into without realising the implications of making what likely is the most expensive thing you’ll ever buy.
It’s a more advanced financial topic that Magical Penny will be exploring in the coming months. However for those of you who are about to buy a house or are considering refinancing my friend Alban has written a 2-part guest-post on one of the more important aspects of buying a home: financing.
Note: This is US-centric article but those of us in the UK will still get a great deal of value from it. The UK mortgage market is mainly variable-rate offers. Fixed rates are available but longer terms are much harder to find than in the US.
Over to Alban….
There are many variables to repaying your home loan easily and saving money along the way. The loan amount, deposit amount, loan features and lender service all impact on your journey as a mortgage holder, but the aspect of home loans which many people are most focussed on is their interest rate, so focus your attention here on the advantages of fixed and variable interest rates and learn how to make an informed decision on one of the most high profile of loan features.
Home Loan Features
Home loans are a competitive market and where there was once a great divide between variable and fixed rate loans, the gap is closing. Variable interest rate loans, also known as adjustable rate mortgages, were typically the sole domain of offset accounts, redraw facilities, and were the only loans which allowed you to make additional repayments. In taking the time to shop around for a home loan you may be able to find a loan with your choice of interest-rate and features whether you are after a fixed or adjustable loan.
The interest rate is such an important feature to consider, because while you may now be able to get traditionally variable rate loan features on a fixed interest rate, the difference between the rates on each loan can differ significantly. For example of the current average adjustable interest rate is 4.19% where the average fixed-rate is 4.88% and this can mean a difference of hundreds a month in your repayments.
Adjustable Interest Rates
Adjustable interest rates seem to be the better option at the moment, and historically variable rates tend to be between 0.5% and 1% lower than an equivalent fixed interest rate. At the same time you need to consider the advantages and disadvantages of a variable interest rate loan according to your own circumstances.
Advantages of variable interest rate home loans:
- It is common to be able to find low introductory interest rates on a variable rate loan. These lower rates may be charged for anywhere from one month to 5 years and can save you hundreds as you settle into the routine of repaying your new loan.
- Even at the end of an introductory period your adjustable interest-rate can continue to save you money on your loan if official interest rates stay steady or drop. This is because variable interest rates are adjusted according to changes made to the official interest rate to manage the economy, as well as based on your lender’s decision on whether to match official rate movements.
- When choosing the type of variable interest rate you can choose one which is adjusted just once a year, and is also capped per year and for the life of the loan. This means that while you will be able to enjoy decreases in your home loan interest-rate you will also know the maximum amount your rate will rise to as your rate may be capped at 2% per year and 6% for the life of the loan so if you apply for an adjustable rate loan at the current 4.19% you know that over the life of your loan you will never be charged much more than 10% interest but during times of falling interest rates you can make considerable savings.
Disadvantages of having an adjustable interest-rate:
- Your home loan interest rates can be adjusted periodically depending on your lender and may vary each month, quarter, year, three years or every five years.
- An adjustable interest-rate varies depending on the index and the margin. The index is a measure of official interest rates, and the margin is the extra amount which your lender adjusts. Therefore you could see a rate adjustment if official rates affect your index rate, or your repayments may increase if your lender adjusts their margin. At the same time while the index rate may move down your adjustable interest-rate may not adjusts downwards and this is something you will need to check with your lender.
How To Decide On A Variable Interest Rate
It is easy to be attracted to an adjustable rate mortgage because of a low introductory rate and lenders know this. That is why if you are applying for an ARM with a low rate initially, you may have to specifically ask your lender to see their annual percentage rate as this is the rate your loan will revert to after the introductory period.
It is also important to remember that when the economy is uncertain lenders will try and take advantage of this panic as well, because many people look to fix their interest rates during unstable times and so fixed rate loans tend to be much more expensive. As a result if you are able to leave your loan at a variable rate during such times and ride out any instability you can save hundreds or even thousands. To help you decide whether you can weather such a storm calculate your repayments using a stress rate of around 2%. The stress rate will show you how much your repayments would be if your adjustable rate rose by 2% and this is a common calculation used by lenders to assess your suitability for a variable rate loan. You can then take your new higher loan amount and see how it would fit into your budget to help you decide whether a variable rate home loan is right for you.
Since your variable interest rate could be on the rise in the future, think about what else might be in your future. Things like car loans or private school expenses can change your budget dramatically and if your circumstances are likely to change make sure you can budget for this as well. Many people who choose an adjustable interest rate loan do so to take advantage of a low initial interest rate, because they know that their income will be increasing in the future. Therefore if you are a first home buyer or plan to excel your career then you may be able to afford to slightly higher costs of a flexible home loan rate, as well as benefit from falling rates in the future.
Alban is a personal writer. He provides information on property investment and helps people choosing the best refinancing loan
Check back on Wednesday for the advantages and disadvantages of fixed rate loans.