Tuesday, February 25, 2014

What mortgage rate should you pick when buying or refinancing a house?

Purchasing or refinancing a home is the single largest financial decision most people make.  In fact, a mortgage payment is likely the largest monthly expense for most people, especially towards the beginning of the mortgage (over time the mortgage payment will become easier and easier to pay due to inflation).  One of the easiest paths to becoming rich is to keep your costs under control, and with the mortgage payment being one of the largest costs, choosing the right mortgage rate is incredibly important.
Deciding what mortgage rate to pick can be a daunting task.  You’ll be presented with a plethora of rates and different terms that may seem confusing.  Here’s a quick guide to choosing the best mortgage rate for your situation:

Is the lowest rate the best?  It depends.
Let’s say you’re presented with three different mortgage rates: 3%, 4%, and 5%.  At first glance, the lowest rate appears to be the most appealing, after all, a lower the rate means a lower monthly payment.  Unfortunately, to lock in the lowest rate, you’ll be required to pay points.  Points help reduce the interest rate in exchange for cash up front.  In a sense, you’re buying a lower rate.

Well then, is it worth paying points up front for a lower interest rate?  To decide whether it’s worth it, you have to ask yourself how long you plan to live in your home.  The longer you live in your home, the more time you have to allow the low interest rate to pay off your upfront investment in points.  The shorter you live in your home, the less time you’ll have for the interest rate to pay off your points.  Here is a general guideline:

How Long Will you live in your house
What rate should I choose?
A few years
Highest rate
Maybe 5-8 years
Middle rate
The rest of my life
Lowest rate

Here’s an example with a $100,000 mortgage:

Cost of points
Best deal
-$2000 (you get money!)
First 39 months
Month 40
$2000 (you pay money)
Months 41 to the end of the mortgage

In this example, if you sold your home after 3 years, the 5% rate would have been the best financial decision.  If you sold your house after 15 years, the 3% rate would have been the best.

Evaluating the best rate
Be honest with yourself and remember that life is full of surprises.  What if you lose your job and you need to move to a new city?  What if you start a family and a single bedroom condo no longer makes sense?  Picking a lower interest rate can cost a lot of money up front and if you have to sell early on in your mortgage, chances are you will have wasted a lot of money on an interest rate that you were unable to take advantage of for a long enough time to pay off the points.  If you’re settling down with a family and things seem relatively stable, a lower interest rate may be your best bet.

Use this as a general guideline to choose your mortgage rate.  There are several calculators online that will help you lock on the specific amount of time it takes to pay off the points.