It's a new year, and for many, it's time to consider a new home! Recently, I've spoken to several people that are moving and buying homes in this unprecedented housing market. In the course of these conversations, two questions are most prevalent 1) which type of loan, or mortgage, is right for them, and 2) how does a loan/mortgage work? The analysis below dives into the main types of loans, and how to choose which type of loan best suits your specific situation.
Mortgage Loan Types:
- Conventional: The terms for this type of loan are typically 30 or 15 years. This loan is the most common and usually has the lowest associated fees. It almost always requires a 20% down payment in cash to avoid the additional monthly property mortgage insurance (PMI) fee.
- Adjustable-Rate: These loans have the same stipulations as conventional in terms of the 20% down payment, but offer a lower initial rate that is locked in for a specified number of years which is typically less than 10. After this period lapses, the rate will adjust to the market rate. This loan is a great option for individuals/families that will only live in a specific home for a specified period that matches the length of the adjustable-rate lock at the longest. Typically, an adjustable-rate loan is suitable for those looking to be in a home for five years or less (i.e. a military member/family that frequently moves).
- FHA: This is a loan for first-time homebuyers that is backed by the Federal Housing Administration. This loan typically requires a down payment equaling 3.5% of the purchase price but carries a funding fee of 2.25% of the purchase price. This loan is likely the best (and only) option for first-time non-military homebuyers that do not have enough cash for a 20% down payment.
- VA: This is a loan for members and veterans of the armed services. This loan is extremely popular among current service members and is the primary reason that I chose to write on the topic of the mortgage decision-making process. This program is great in the sense that it allows service members to own a home, but can be extremely harmful if used irresponsibly. The VA loan allows the buyer to purchase a home with 0% down and no PMI but does charge a funding fee. Often, the funding fee leaves the buyer underwater on the house (owing more on the house than it is worth). Listed below are the funding fees for the VA loan which are dependent on whether or not it is the first time the VA loan is being used, and the amount of the down payment. For example, a first-time homebuyer who puts $0 down on a $400,000 house will pay a whopping $9,200 funding fee. This is money that is lost the moment the house is purchased and does not go toward paying down the mortgage.
VA Loan Funding Fee % By Downpayment and Homebuyer Status
Okay now for the fun stuff; how do I decide which loan is best for me? Well, that comes down to the numbers. First, understand that there are two categories of costs when entering into a mortgage:
- Fees and Interest: This is money that comes directly out of your pocket, and into the bank's pocket. This comes in the form of origination fees, funding fees, any other fee you can think of, plus mortgage interest. Fees and interest are straight profits for the bank, and the more expensive the house, the more money they pocket. Banks do not issue mortgages and approve people to buy houses that far exceed their budget out of the goodness of their heart, they are looking to make a profit. This is why it is important to shop for a house that is within your budget.
- Opportunity Cost: This cost is the forgone return on the money that you are putting into a house. For example, if you put 20% down on a $500,000 house and hold onto that mortgage for 30 years, you will incur an opportunity cost. The U.S. housing market has a historical appreciation rate of around 3%. The U.S. stock market has a historical appreciation rate of around 10%. That 7% difference would be your opportunity cost.
I choose to focus solely on fees and interest in this analysis as these are the most troublesome costs borne by the majority of homebuyers, especially those who frequently move locations (such as military members). Opportunity cost is less intangible, and most families will not consistently invest the money they would have spent on a house. You can only realize the 7% opportunity mentioned above if you stay invested over the lifetime of your homeownership. This 7% opportunity also ignores the risk tied to being in debt on your home. Fees and interest rapidly become detrimental when service members opt for a VA loan with 0% down. In a few years when they are ready to move, the purchaser has not paid much down on the mortgage, and any appreciation on their house is quickly negated by real estate agent fees and closing costs. This is a never-ending cycle for those who do not build equity in their home and continue to choose the VA loan's 0% down option. This situation is unfortunate, as building up home equity is one of the most common ways American families have historically built wealth.
Now, let's crunch the numbers. Here are some assumptions that I made with the below analysis:
- Home Purchase Price of $400,000
- Ignore all closing costs outside of funding fees. I am only comparing mortgage types over different periods of time, thus nullifying closing costs that are similar to every mortgage. These costs are similar across all types of house transactions including title insurance, appraisal fees, and other closing costs.
- The 5/1 ARM option involves selling the house at 5 years. I only included this option to illustrate that if you can afford a down payment of 20%, this can be one of the cheapest ways to purchase a house in the short term.
- All funding fees for the VA and FHA loans are paid upfront in cash. This assumption makes these types of loans easier to analyze and demonstrate the cost in a way that is easier to understand. In reality, many homebuyers roll the funding fees into the mortgage, driving up the loan amount so that it exceeds the purchase price of the home. This fee is still a direct cost, it is just not realized until the house sells and the homeowner has to pay that amount back to the bank in the form of a higher mortgage.
- There are no scenarios where one would pay PMI. Most homebuyers will not choose a conventional loan unless they have the required 20% down.
Mortgage Loan Types and Assumptions
Total Cost and Fees of Mortgage Based on Years Held
Total Cost of Mortgages From 3-30 Years
Total Cost of Mortgages From 3-5 Years
1. The most expensive way to buy a house is a VA loan with 0% down. This makes sense intuitively, a 0% down payment results in the largest mortgage, interest, and charges the highest funding fee. This loan is significantly more expensive over a 3-5 year time period, as shown by the second graph above. Mortgage lenders will push this type of loan on military members, so it is important to do your research. Assuming you are a subsequent VA loan user (meaning you have used the VA loan at least once before), if you can put just 5 % down on a $400,000 house, you will decrease your mortgage cost by over $9,000! By putting $20,000 down, you immediately save yourself $9,000 for an effective rate of return of 45% on your down payment. This is an outstanding risk-free rate of return! In this scenario, it likely makes sense to put forth a down payment, if it is at all possible, to minimize your funding fee and overall cost of lending. That being said, the VA loan can be a great way for military members and veterans to own a home, BUT it should be used responsibly so that it does not stagnate the building of wealth.
2. The 15-year conventional mortgage is a much cheaper option than ANY of the 30-year options. This comes at the cost of a higher mortgage payment of $2,135 in our above scenario. If you are going to be in a house for more than 5 years and can handle the increased mortgage payment, this is by far the cheapest way to own a home! Not only will you pay your house off much quicker, but you will save over $120,000 in interest over a 30-year mortgage option. When the time comes to sell your home you will recoup those higher mortgage payments, whereas you will automatically lose all the money put towards the higher interest payment on a 30-year mortgage. This amounts to savings of $124,643 in our scenario. That's a lot of money that could be put elsewhere.
3. The Adjustable Rate Mortgage (ARM) is a great option for those who know that they will be in their house for a short period of time, want to minimize interest and fees, but can only afford lower monthly payments. In the above scenario, the ARM loan produces a very low amount of interest and fees over 5 years when compared to the rest of the 30-year options. The adjustable-rate loan has only $5,500 more in interest over 5 years when compared to the 15-year conventional, but the mortgage payment is $848 less per month. This loan does have a higher interest rate than the 15-year conventional, but it allows families the flexibility to do other things with their money thanks to a lower mortgage payment.
4. The FHA loan is an excellent option for non-military, first-time homebuyers that might not have 20% in cash to put down. In this analysis, the FHA loan only results in a higher mortgage payment of $180 per month, however, this can be a lifesaver for those that can only afford to put 3.5% down. As you can see, the cost differential between the FHA and a 30-year conventional loan decreases over time when viewed as a percentage of the loan. In other words, if you are going to be in one spot for more than 5 years, the higher interest rate and funding fee will mean less and less as time goes on. The cons with this type of loan are similar to the VA loan. The exact buyer that an FHA loan is designed to help (young families), often gets burned because they are likely to move! An FHA is NOT ideal for a typical starter home or a home that will quickly be outgrown in 3-5 years by an expanding family. This family will move and likely not have much equity built up in their house. Sadly, this may be the only real option for them to become homeowners without paying PMI.
So what do these findings mean for you and your family? The purpose of this analysis is simply to point out that the numbers REALLY matter. Whether it be decimals on the interest rate or type of loan, these things can add up to tens of thousands of dollars of differences in mortgage costs. The main takeaway: It is critical to understand how much you are paying in interest and fees, and how that can change based on which loan type you choose and how much money you can afford to put down.
Appetite and preference for debt also play a role in this decision. For example, a family that wants to minimize debt and can put 20% down should choose a 15-year conventional loan, whereas a family that wants to minimize monthly payments at all costs should choose a 30 year conventional FHA with 3.5% down, or VA with 0% down. This is where opportunity cost comes in, but with that, the risk of having more debt also needs to be considered. Housing prices don't always go straight up every year and the current housing market growth is likely not sustainable. Paying off a mortgage quickly, or putting more down on a house is an active choice to become debt-free as soon as possible. While this is the right answer for some families, others would rather invest money into the stock market and keep their mortgage payments to a minimum with the current rates (which are historically low). If families spend less than they make and invest consistently, they will likely become wealthy no matter what mortgage decision they make. There are many paths to wealth, and everyone's path is a little different. There is no one right answer for everyone, but after assessing your goals and analyzing the numbers, you can come to the best decision for your family.