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When you’re ready to purchase a home, you’re most likely not going to pay everything upfront with a briefcase of cash. The beauty of home buying is that it’s one of the few purchases you make with a considerable amount of leverage—plain talk: you borrow most of the money from a bank.
When it comes to home buying, determining how you want to finance your purchase using a mortgage loan is one of the most important decisions to make—as you’re most likely stuck with it for at least a decade of your life. Check out this post to learn why leverage makes home buying a worthwhile investment. There are so many mortgages to choose from, so we’re here to help you navigate the scene.
What we recommend:
We often advise clients to compare 2 types of mortgages: 30-year fixed and adjustable rate mortgages aka ARMs (generally 7/1 or 10/1 ARMS).
What are they?
Generally, 30-year fixed mortgages are easy to understand — you effectively pay the same interest + principal payment for 30 years to pay off the mortgage. An adjustable rate mortgage is a little more complicated. A 10/1 ARM starts out the same as a 30-year fixed, with 10 years of set interest and principal payments. At the end of that 10 years, the principal payment schedule doesn’t change but the interest resets to a floating rate, usually the SOFR (Secured Overnight Financing Rate) + a spread. As a general rule, you do not want the mortgage to ever reach the floating-rate stage as those rates can be substantially higher, so getting a 10/1 ARM usually involves an unstated commitment to refinance or sell within 10 years.
How do you make a decision between the two?
In situations where there is a chance you will sell your home in the next decade or two, we typically recommend an ARM over the 30-year fixed. For example, if you are offered 4.50% for a 30-year fixed and 4.00% for a 10/1 ARM on a $1M mortgage, you save $5,000/year or $50,000 over 10 years on interest payments by taking the ARM. However, you then have to deal with having to refinance within the next 10 years to avoid hitting floating rates at whatever future interest rates might be at the time, so you need to ensure you are getting paid enough for taking that risk.
For people confident their purchase is a “forever home” or at least their home for the next 20+ years, a 30-year fixed mortgage may be better, as it locks in interest rates we have today (...which are sadly much higher than back in 2021!) You may worry they’ll continue to go up over that entire period. However, one element to note is that “locking-in” the last decade or so of a 30-year mortgage has a reduced impact since the outstanding loan balance during those years becomes much lower, unless you cash-out refinance to take equity out.
The obvious question is why we didn’t recommend a 15-year mortgage. A 15-year mortgage means that the principal is fully paid over 15 years versus over 30 years on a 30-year fixed mortgage. This seems reasonable, but the problem is that when you make principal payments, you are earning the mortgage rate on a pre-tax basis (and even less after the interest deduction is accounted for).
So, $1 paid toward a 4% 15-year mortgage is earning 4% pre-tax and less on an after-tax basis. This $1 could probably earn a higher return in a moderate or aggressive portfolio long term (6%–7% expected return yearly) so from a wealth maximization perspective, lowering the principal payments by going to a 30-year amortization schedule drives a higher wealth expectation (as long as you take the $1 you would have used for principal and invest it). Obviously, portfolio returns are not guaranteed, but the chances an investor comes out ahead over 10 years is over 80%.
In many states, interest-only (IO) mortgages are available. These mortgages tend to not require any principal payments for the first 10 years, and then the principal is amortized over the last 20 years. Again, like with ARMs, IO mortgages usually involve an unstated commitment to refinance or sell within 10 years because individuals don’t want to deal with the higher payment after Year 10.
For the same reason that a 30-year mortgage is preferable to a 15-year mortgage in terms of wealth maximization, IO mortgages can be more attractive than mortgages that require principal paydown. This is because you can take the money that would have been required for principal paydown and invest it at a higher expected rate of return.
Another great resource to check out are blogs by The Mortgage Professor. He has resources on all things home buying, but specializes on answering mortgage specific questions. We're the first to admit that we aren't the top experts on mortgages, so check out his blogs here!
If you’re looking for a specific yes / no answer, and want to walk through this decision with us? Reach out to me at email@example.com and schedule a call to set up a no-cost, no-obligation process for prospective clients.
Read more about all things home buying here:
- To Buy or Not to Buy a Home?
- How Much Home Can I Afford?
- Where Should I Save Up For a Home?
- How to Make Your Offer Stand Out in a Crowded Market
Interested in learning more about whether a home purchase is right for you and how you can best save for it?
Steward ‘s mission is opening up the 1%’s wealth strategies to America’s up-and-coming families with a combination of 21st century tech and trusted advisors. We help families determine how, where, and when to invest and save on taxes in plain-English, with minimal time and effort. Steward can help you determine if a home purchase makes sense, how much home you can afford, and how to invest and save in the most efficient way. Give it a try here.