Suppose you're ready to buy a house and need a mortgage of $110,000. Would you rather your monthly payments be:
1. $6492. $787
This is a no-brainer, you say to yourself. Of course I would prefer to pay $649. But if you looked ahead a little bit, you might make a different decision.
The $649 would last for only 12 payments, courtesy of a one-year
adjustable rate mortgage at an initial interest rate of 5.9 percent.
In the second year of the typical ARM, your payment would rise 2 percentage points, which would give you a rate of 7.9 percent and a payment of $787. But by the third year, an ARM hooked to the one-year Treasury index would require a payment of $807 at today's rates.
Unless you planned to stay in the house only three or four years, you probably would be unwise to choose the ARM.
Another choice would be the traditional 30-year mortgage, currently offered at about 7.7 percent. On a $110,000 mortgage, that would require a monthly payment of $779.
This is a safe choice - your rate won't change and neither will your payments for as long as you live in the house or keep the mortgage. But you're paying top dollar for this long-term safety. Maybe you don't need that much safety.
If you're buying your first house or know you'll be transferred in the next five years or are pretty sure this isn't the forever-after house of your dreams, why pay so much for a mortgage?
A better option might be a seven-year balloon, which generally carries an interest rate about half a percentage point below the 30-year mortgage. Currently, you can get a seven-year balloon at a rate of 7.2 percent and a monthly payment of $745 on a $110,000 mortgage.
With a balloon mortgage, the interest rate and payments remain the same throughout the life of the loan. But when the balloon comes due, you have to pay off the loan. Generally, that means selling the house or refinancing. Some balloons give you the option of extending the mortgage but at whatever interest rate prevails atthe time.
Balloon mortgages are perfect for people who can't live with the uncertainty of an ARM but know they will not be in a house more than six or seven years.
The final payment in the list above - $995 - looks intimidating but will cost you the least, by far, in the long run. That would be the monthly payment on a 15-year mortgage of $110,000 with an interest rate of 7.2 percent.
First-time homebuyers generally cannot afford the stiff payments on a 15-year mortgage, but many move-up buyers and refinan- cers choose this option because they love the quick equity buildup that results and exult in the knowledge that they will be free of a mortgage in the time it takes an infant to grow to adolescence.
The following chart compares a $110,000 mortgage with a 15-year mortgage at 7.2 percent interest and a 30-year mortgage at 7.7 percent interest:
How mortgages compare
30-year, $110,000 mortgage. Interest rate: 7.7 percent
Year Interest Principal Balance
1 $7,405 $2,280 $104,105
2 $7,955 $1,730 $102,375
3 $7,817 $1,868 $100,507
4 $7,668 $2,017 $ 98,489
5 $7,507 $2,178 $ 96,311
6 $7,334 $2,351 $ 93,959
7 $7,146 $2,539 $ 91,420
15-year, $110,000 mortgage. Interest rate: 7.2 percent
Year Interest Principal Balance
1 $7,079 $4,861 $105,138
2 $7,422 $4,518 $100,620
3 $7,086 $4,854 $ 95,766
4 $6,725 $5,215 $ 90,550
5 $6,337 $5,603 $ 84,946
6 $5,920 $6,020 $ 78,925
7 $5,471 $6,469 $ 72,456
Note that in the sixth year of mortgage payments, you begin paying more on the principal than is going toward interest with the 15-year mortgage; meanwhile, interest payments on the 30-year mortgage are still more than three times the amount going to principal.