It seems that you cannot listen to the radio for more than a few minutes without hearing the pitch from some mortgage company about how they can give you an unbelievable deal on refinancing your house.
Since interest rates are rising slightly but still low and most people have refinanced, the dynamics of the mortgage market are changing.
Two pitches seem common now. The first is a bid to lower the monthly payments. The second is to “accelerate” the payoff so you pay less interest over the life of the loan. Some caution is appropriate in both cases.
The mechanics of loans are straightforward, but not necessarily simple. You have only four basic variables: principal, interest rate, length of payback period, and payment. By tinkering with any of these four, you can adjust the others.
But nothing is free.
Creating a benefit for one variable causes a change with another, perhaps less desirable. Remember the cardinal rule for lenders, which was expressed in simple form by Will Rogers: “I am more concerned about the return of my money than the return on my money.”
Some promises are for very low monthly payments. Other pitches complain that so much of the payment goes to interest rather than principal in the early part of the loan. All these promises are aimed at letting the borrower get more from the deal. In such situations, looking at the circumstances from the perspective of the other side is often useful.
Just keep in mind that if you were the lender, you would want a fair interest rate and repayment of your money. Changing the particular pattern of the payments would be fine, as long as you receive what is fair.
Be cautious about low payments. Just by using the math for loans, you will find that low payments can only come from longer payment periods, lower interest rates, or less payment going to the principal.
Choosing a longer payment period, e.g. 40 years versus 30 years, reduces the monthly payment but does not change the interest rate. The payment decreases because you pay back principal in smaller amounts each month, but the total interest paid increases since you pay for a much longer period.
Interest rates that are initially below the market rates are usually tied to a higher rate later. Nothing is free. The pattern can be rearranged, but the lender expects a fair return when all is done. As the borrower, you need to examine the entire period covering both the lower and the higher rates to determine how you will handle the difference in cash flow requirements.
Paying less to principal is another way to lower the monthly payment. Some of the dangerous loans from a few years ago are no longer available, fortunately. These loans had low payments that only covered the interest or sometimes even less, so the loan balance actually increased. Such loans would never be paid off.
Another pitch is to “accelerate” the loan. The appeal is that more money goes to principal and the total interest for the life of the loan is less. This is absolutely true, but the fact is that the payment must increase significantly to make the deal work, an item that the pitchman cleverly leaves out.
The new kinds of loans have intriguing traits that may be useful, and certainly may seem appealing. Remember that getting into a particular loan is easy. Be certain to plan how to get out when your situation requires it. Do not let the loan details surprise you.
As always, investigate before you sign. Seek professional advice if you have questions.
Mark Sievers, president of Epsilon Financial Group, is a certified financial planner with a master’s in business administration from the University of California, Berkeley. Contact him at [email protected]