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Understanding Mortgages in Your Financial Plan

Understanding Mortgages in Your Financial Plan

July 18, 2021

Fixed Vs. Variable Mortgages

Hi everyone, and welcome back to Melissa Making Cents!

As a CERTIFIED FINANCIAL PLANNER™ and a financial coach, I'm aware that home buying is always on people's minds. Even if you aren't in the market to buy a home, there's that little thought in the back of your mind that's prepping you to get there. Many American's use their ability to purchase a home as a benchmark for how they're doing financially. I figured there's no better time to do a little recap on some home-buying basics with the current housing market! Even if you aren't in the market right now, this information should come in handy one day down the line. 

That brings me to our main topic for today… MORTGAGES. Mortgage is a word that carries a certain gravitas. By that, I mean, even the mention of a mortgage or mortgages is enough to get some people nervous. After all, a mortgage is a huge commitment.  Many spend a good portion of their time creating a financial plan to put aside a down payment. Next thing you know, you've picked out a home, and you're committing to paying for it for 15 to 30 years. While not everyone will stay in that house for the entirety of a mortgage, it's still quite the undertaking. 

As I mentioned earlier, the home buying (and renting) market is absolutely crazy right now. For that reason, it'll be good to brush up on our home buying basics. That's why today, I've chosen to talk about fixed versus variable mortgages. Some of you are scratching your head wondering what those terms are - don't worry, we'll get to that. After I've talked about what Fixed and Variable mortgages are we'll do a little deeper dive into each of them to dissect the crucial information that you need to know if you're planning on to buy a home, well… ever. 

Mortgages… The Basics

Melissa Cox CFP explains the basics of mortgages

Let's start by talking about what a mortgage is. This is a little basic, and if you're already familiar with the basic mortgage, feel free to fast forward a little to the next section. A mortgage is, in essence, a home-buying loan. You apply for a mortgage through a bank, credit union, or other financial institution, and they make an assessment about your ability to repay the loan. They take your credit score, credit history, income, expenses, and all of that great stuff into consideration when they make a decision on whether or not to lend to you. 

There are basically three moving pieces to the average mortgage. These pieces are always existent in a mortgage, and they affect how high your payments will be and vary from person to person. 

Mortgage Length 

Melissa cox CFP explains how the length of your mortgage effects your finances

The first moving piece is time. You'll be paying a mortgage from 15-30 years, but that's not just because you make incremental payments and hope you get there. The institution you're borrowing from will either assign or allow you to pick a time in which you must repay your borrowed money (plus interest). The most common mortgage length is a thirty-year mortgage. While you'll be paying more in interest over time, and you'll be paying longer, the longer your mortgage, the less your monthly payment will be. That's why many (the majority of people) opt for a thirty-year mortgage, which is generally the longest you can get. A longer mortgage can also provide you with flexibility in your financial plan.

Mortgage Interest Rates

Melissa Cox CFP explains interest rates on your mortgage

The next moving piece is interest. Unfortunately, this isn't something you really get to pick. However, you can influence your mortgage's interest rate. If you're interested in getting the best interest rate you can, make sure that your credit score is up to snuff before you apply for your mortgage. This can be done over time with a little hard work! Make sure you make any payments (especially towards credit cards) on time, keep long-standing accounts open and active, work on paying down any large outstanding debts, and avoid making any hard inquiries on your credit. You may also lower your interest rate by shopping around for good deals. This is odd, but many financial institutions will have "blockbuster" events. For example, on black Friday, some institutions have special rates on loans. While I'm not sure that would translate apples to apples with mortgages, it's always something to be on the lookout for. Lastly, if you want to minimize your interest rate, work on getting a shorter mortgage. Often, the longer your mortgage is, the higher your interest rate will be. The flip side to this is your monthly payments will be larger. 

You can check current interest rates online here!

Mortgage Principle

Melissa Cox CFP explains mortgage principal

The last moving piece is principal. Principal is the original borrowing amount of your mortgage. This is the money that you'll be working to pay back and doesn't include interest. The key here is to make sure that you're living within your means because your principal amount will affect both uour monthly payment and your interest rate. 

Let's pause here. I've covered a lot about mortgages in a short amount of time, but I've left out something. It's essential to work with a financial coach or CERTIFIED FINANCIAL PLANNER™ if you are contemplating a mortgage. Not only can a financial planner help point you in the right direction to get your mortgage, but we can also work with you over time to improve your credit score and make sure you're in the correct position to be taking out a mortgage in the first place. Believe it or not, with proper financial planning, you don't have to make oodles of money to buy a nice place to live, but you do have to have a certain amount of patience and trust in the process. 

Fixed Mortgages

Melissa Cox CFP describes fixed rate mortgages

Okay! We're finally to the good stuff. Let's start by going over what a fixed-rate mortgage is and what makes it fixed. Luckily this is actually relatively basic and easy to comprehend. A fixed-rate mortgage is one where you have a fixed rate! That is - the interest rate on your mortgage is set in the beginning and never changes. This, in turn, means that your monthly payment will always be the same, which could be very important if you have a low-risk tolerance. 

For example, if you were to take out a $1000 mortgage at a 10% interest rate over 30 years (don't do that), you'd be making monthly payments of $36.63 each year for 30 years. 

Variable Mortgages (Adjustable)

Melissa Cox CFP describes Variable Rate Mortgages

Variable-rate mortgages are just a little different. They are the odd-balls that spurs this article's existence. While fixed-rate mortgages have a set interest rate and monthly payments that don't change, variable rate (or adjustable-rate) mortgages have interest rates that change with the Prime Rate. This means that your interest rate may go up or down overnight, and your monthly payment could be larger or smaller depending on that fluctuation. 

Melissa Cox CFP describes historic mortgage rates

Variable-rate mortgages often have lower interest rates but require a specific risk tolerance from the borrower. The significant problem that many have with a variable rate mortgage is that it's sort of a interest rate gamble. While you can sort of predict what may happen with the market, no one really knows, and we can only work with current information. For example, if you'd taken out a variable rate mortgage three years ago, you would have no way to know something like the coronavirus would happen. While the pandemic seemingly lowered rates, that isn't always going to be the case. Sometimes an unforeseen event like inflation could occur, which could cause your interest rate to go up.   Looking at the historic rates above... would you want to risk the larger rates?

Interest Rates and Risk Tolerance

Melissa Cox CFP compares fixed and variable rate mortgages

Interest rates and monthly payments are the hallmark differences between fixed and variable rate mortgages. Where fixed-rate mortgages have a fixed interest rate, variable rate (adjustable rate) mortgages do not. The primary difference this causes is that your monthly payment may go up or down at times, which is doable for some and less so for others.

What fluctuating interest rates really boil down to is risk tolerance and your financial ability to absorb it. Many financial professionals are too quick to jump on the variable-rate mortgage train.  An idea behind this is to get in at a low variable rate and refinance later.  Instead, it could be viewed as a responsible decision for someone to take the more conservative and safe fixed-rate mortgage option. However, when it comes to deciding which is better for you and your family, the decision is yours. 

A good financial representative or financial planner may be able to help you make an intelligent and informed decision about which type of mortgage may be right for you. We can help you determine what's currently happening in the market and what may happen; however, as I said before - no one really can predict what will happen. We may also help you raise your credit score and financially plan to create an optimal savings account, which will help you along your journey with mortgages

Flexibility for relocation/lower payments initially

When you take a variable rate mortgage, your lender will give your interest rate according to their prime rate. In other words, the bank has a special interest rate called prime that's offered to those who take a variable rate mortgage. Prime interest rates are lower than the regular rates, which means you're getting a better rate for taking out a variable rate mortgage, to begin with. However, when the bank issues you your prime rate, it will be at either a premium or a discount. Generally, this will be seen as either a +% or a -%, and it will remain that throughout your time with the mortgage. That means when prime goes up, you'll still have your premium or discount, which will affect your rate. 

For example, if prime is 2.5%, and your lending institution has given you a discount of -.5%, your prime will be 2%. If prime were to go up to 3%, your new prime would be 2.5%. If prime were to drop to 2%, your prime would be 1.5%.

Alternatively, if prime were 2.5%, and you received a mortgage with a premium of +.5%, your prime would be 3%. If prime were to go up in this example to 3%, your new prime rate would be 3.5%. If prime were to drop to 2%, your prime would be 2.5%.

Getting prime with your mortgage means that your rates will likely be lower than a fixed-rate mortgage at the beginning of your term (especially if you have a discount. This makes it an excellent strategy for someone who isn't planning on staying in the home for the duration of the mortgage or someone who believes that their income will go up over time. For a moment, consider that you're someone who wants to purchase a home but knows they'll be moving out of the area in the foreseeable future. In this case, you may want to consider a variable rate mortgage tied to the prime rate because you'll be making payments during the time when you know the interest rate will be lower.

Which Type of Mortgage is Best for You?

Melissa Cox CFP asks which mortgage is best for you?

Which type of mortgage is best for you depends on a variety of factors. For starters, your income will likely be a massive part of your decision-making process. That will determine how much income you can allocate towards paying your mortgage each month. On top of that, you also must consider the duration, interest (of each loan), and principle borrowing amount. All of these principles will have a hand in dictating what will happen with your mortgage's interest rate on either plan. So my best piece of advice for you is to talk with a financial planner long before you're planning on taking a mortgage. A financial planner can help you develop a customized financial plan to save, improve your credit score, and build an emergency fund that could help you along the way. 

However, your ability to absorb risk is likely the most crucial factor when considering which type of mortgage you should take. If you and your family can cover fluctuations in your bill, a variable rate mortgage may very well be the way to go. It does offer a lower initial interest rate, but keep in mind that no one knows what will happen with the market tomorrow, next month, or next year - we can only work off current information and predictions. You may also just be more comfortable with the steadiness and predictability of a fixed-rate mortgage. On the one hand, you'll have a higher interest rate, but on the other hand, that rate won't be subject to change, and you'll be able to plan for it years down the road. 

A CERTIFIED FINANCIAL PLANNER™ Can Help You Understand Which Mortgage Options are Best For your Financial Plan

As a CERTIFIED FINANCIAL PLANNER™, Melissa Cox helps clients create customized financial plans that include mortgages

Either way, I can't stress how important it is to meet with and speak to a financial professional. We can help you create a plan to tackle an existing mortgage or take on a new one. If you're interested in learning more about fixed-rate or variable-rate mortgages, please, feel free to call or email to schedule an appointment with me. Together we can create a financial plan that helps you tackle a mortgage.

Schedule a call with Melissa Cox CFP®

Until next time...this is Melissa Making Cents!

Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.

Read last week's blog post by Melissa Cox CFP®