Buying a home means more than just committing to raising a family or living out one’s golden years in a particular house. It usually comes with financial obligations in the form of a mortgage. It is therefore important to prepare for the possibility that mortgage interest rates that have been at records lows for years may be rising soon.  In particular, this could affect how a new homebuyer approaches whether to consider adjustable rate mortgages (ARMs) in addition to fixed-rate mortgages. 

Fixed-rate mortgages

A fixed-rate mortgage is the most traditional form of a mortgage, locking in both the interest rate and monthly payments for the life of the loan.   These mortgages can vary in length.  The standard is the 30-year mortgage, but a 15-year fixed mortgage offers purchasers a quicker amortization schedule and ownership timeline.

Regardless of the length, many prefer a fixed rate mortgage because the repayment obligations are clear from the amortization table.  They do not change the course of the loan, offering borrowers predictability —offering the peace of mind that comes with stability and avoiding interest rate fluctuations. 

To be clear, fixed rate mortgages can be appealing if you think rates are lower now than they will be in the future. With rates near historical lows and seemingly poised to rise, locking in a rate could make sense for many borrowers now.

Adjustable-rate mortgages (ARMs)

An adjustable-rate mortgage (ARM), unlike a fixed rate mortgage, has a fixed interest rate for a few years with the 5-year ARM being the most popular (3, 7 and 10-year ARMs are also common) with the amortization ordinarily extending over 30 years.   Once this initial fixed rate period ends, the monthly payments will vary as market rates change.  While many ARMs offer limits on how much your rate might increase in a given adjustment period or over the life of the loan, a purchaser selecting an ARM should understand that if rates rise from these levels there interest obligations (i.e., monthly payments) may reset at much higher levels.

For those planning to stay in their home beyond the fixed period at the beginning of an ARM, the risk to rising rates at this point in the interest rate cycle may offset any advantage to reducing near term interest payments.   Even if you might have been more likely to take on the benefits of an ARM mortgage, a fixed rate at this point may just offer you more safety, security and flexibility. 

Start exploring rates where you live here.

When you refinance a mortgage you pay off your existing mortgage loan and replace it with a new mortgage.  Homeowners might want to refinance for several different reasons.  Some of the most common reasons include obtaining a lower rate, shortening the mortgage loan term, converting from a fixed-rate mortgage to an adjustable-rate mortgage (or vice versa) and tapping into the home's equity to finance a major purchase or consolidate debt.  Each case can involve benefits, but also poses pitfalls.  Since refinancing can cost as much 1% and  - just like taking an original mortgage - requires an application, title search, and appraisal fees, homeowners need to carefully analyze all of the factors involved before initiating the process to determine whether their refinancing is truly beneficial.

Again, some of the most common reasons for refinancing are:

1.  To Obtain A Lower Interest Rate 

Lowering the interest rate on an existing loan is one of the best reasons for refinancing a mortgage.  The rule of thumb historically was that it was worth refinancing if your interest rate could be reduced by 2% at least.  In the current low interest rate environment, many lenders have made the case that a savings of 1%, or even less, is enough of an incentive to refinance.  

Reducing your rate helps you save money by lowering your monthly payment.  For instance, a $100,000 home with a 30-year fixed rate mortgage that has a 3% interest rate will have a monthly payment of $421. With a 2% interest rate, the payment will be reduced to $369.  If you want to simulate more payment scenarios use this mortgage calculator. 

Alternatively, you could obtain a lower rate and get a mortgage that allows you to continue to pay the same payment each month ($421, in the above example) and to apply the difference between the interest you pay and the lower interest you could pay to lowering the total owed – i.e., amortizing the mortgage principal.   This strategy would enable you to pay off your mortgage years earlier. 

Check 30 year mortgage refinance rates where you live.

2.  Shorten the Loan Term 

Whenever interest rates go down, homeowners frequently have the chance to refinance their existing loans to a shorter term that enables a much quicker amortization and, hence, more home equity built.  For the $100,000 home with a straight-line 3% 30-year fixed-rate mortgage that involves a monthly mortgage payment of $421, approximately $171 is attributable to paying down or amortizing the mortgage.  If you were to refinance at 2% and shorten the term to 15 years, the monthly payment would go up to $643, but over $440 of that amount would be attributable to mortgage amortization in the first month (and that amount rises from there).   You can play with your own numbers and extrapolate how shortening your term loan would accelerate amortization of your own mortgage with BestCashCow’s mortgage calculator.

If you have a fixed-rate mortgage in a rising interest rate environment, it will make much less sense to shorten the loan term in order to pay off your mortgage quickly.  Instead, you would be better served by adding to your monthly mortgage payment or by making annual or semi-annual lump-sum payments in order to pay down the mortgage balance.  Before making any excess payments, you should be sure that your mortgage lender permits your mortgage to be paid down without a penalty.

3.  Convert Between An Adjustable-Rate Mortgage and Fixed-Rate Mortgage  

Although an Adjustable-Rate Mortgage (ARM) will often start out with a lower rate compared to a fixed-rate mortgage, frequently periodic adjustment will result in increased rates making them higher than fixed-rate mortgages that are being offered.   The impact can be costly in a rising rate environment, even though many ARMs have escalation clauses that limit the amount that the ARM can adjust upwards each year.  Converting to a fixed rate mortgage can often both lower the interest rate and fix the interest rate for the longer term.  It also eliminates the worry about interest rate increases in the future. 

On the other hand, it can be financially beneficial to convert from a fixed-rate loan to an ARM when interest rates are falling.  The ARM's periodic rate adjustments can result in lower interest rates and monthly mortgage payments that are smaller, eliminating the need to refinance in order to take advantage of lower interest rates each time they go down.  Even in a stable or rising interest rate environment, it might also benefit homeowners who are not planning to stay in their home beyond the fixed period of the ARM loan to convert to an ARM, as the rate during the fixed period (usually 5 years) is often lower than that for a long-term fixed rate mortgage.

4.  Consolidate Debt by Tapping Equity

Refinancing your home to consolidate your debt is the most common reason that homeowners refinance.  It is often attractive to pay for major expenses, such as Obamacare premiums, college education and home remodeling costs, with the equity that you have built in your home.  It is often not only a lower interest rate than the other types of loans that might be available, but because mortgage interest on your primary and secondary homes is usually tax deductible, it can be a solid tax planning strategy.   But, while it may be a financially sound idea, the reality is that, especially if you are approaching retirement, it may not be wise to increase the length and/or amounts of your monthly mortgage payment.

Those who need or want to tap into their home equity for major expenses will often find that a home equity loan is a more attractive option, as it does not require the same amount of work or the same costs. 

See the best home equity rates where you live here. 

There are a lot of people who often wonder whether they should think about paying off their mortgage early. The answer is rather simple.  Most of the time, the answer to any given situation would be a resounding “yes”.

There can be a world of freedom and happiness out there for you once you have the biggest monthly expense no longer looming over your head. 

Regardless of what stage you are at in life, it is important to recognize that the most successful and happiest retirees are those who eliminated their mortgage payment or at least drastically reduced it before they started in on their retirement.    Quite simply, no matter what you are age, the stress of a mortgage being lifted will end up being well worth its weight in gold. After all, paying off your mortgage will end up taking a huge concern off of your plate.

Of course, having a outstanding mortgage can give you the flexibility to essentially walk away from a bad purchase with limited liability, as many people did in 2008 and 2009.  And, you never know just how the market is going to go and there is no guarantee it will go up.

Nevertheless, in an ordinary environment, you do not easily walk away from a mortgage with complete impunity.  It is a liability that is not going to easily be forgiven, and any proper retirement planning does not involve defaulting on a mortgage.  If you are able to pay your mortgage off by the time that you retire, you will have added peace of mind. It cuts back on the amount of income that your safety net for retirement will need to take care of. If the burden of paying your mortgage goes away, you will have more freedom with your budget for the happier things in life.

At any stage in life, extinguishing a mortgage creates what is known as a deflationary moment. A deflationary moment is something that will not happen often in life, as there are not a lot of services and goods in our daily life that are becoming less expensive.  (It doesn't matter if you are looking at daycare, gasoline, land, groceries or something else, things are always getting pricier. With this sort of inflation, when will you see deflation? The answer is actually rarely, if ever.)  The prices will generally always be on an upward climb.

The deflationary moment happens because you deflate the money that goes out the window for daily life without impacting your lifestyle.  After you no longer have a hefty mortgage, you gain flexibility that allows you to live where you want and in the size home that you want. Some folks will choose a home that is a bit smaller and fits their needs a bit better after retirement.

When you own a home without a mortgage, you can easily transition into a smaller home that is a lot easier to maintain. Maybe you want to have the money so that you can buy two homes that are in very different locations, such as the one that is in the mountains, or one that is at the beach. When you want to spend several months in one location with your grandchildren or extended family, or you are hoping to take care of someone in need, you will not have to worry about a mortgage payment while you are away. 

The flexibility will dramatically increase after you pay off your home, which will give you a chance to live where you want and how you want.

When should you think about pulling the trigger to pay off your mortgage?

Whenever people ask how much they have to have in the bank for paying off their mortgage, it is difficult to have an actual number. The best advice is the one-third rule. This means that if you can pay off your mortgage while not using any more than one-third of the non-retirement savings that you have, you should consider paying off your mortgage today. 

As an example, if you owe about $55,000 on your house and you have roughly $190,000 in your savings, excluding any IRA or 401(k) funds, you can look at the one-third rule. You will have the ability to pay off the mortgage, plus you will have plenty of cushioning left over for any unexpected expenses. If it will cost you more than one-third of any non-retirement savings that you have to pay your mortgage off, you should wait. It can cause more stress over the long term if you are lacking the cash in your bank simply because you paid off your mortgage. 

Here are 5 steps that you can follow early in life to pay off your mortgage faster:

1. Buy A Home You Can Afford

When you are looking to finance a house, you will need to be prequalified. The bank is going to look at the overall picture of your finances and then spit out an amount that you can get a loan for. Some will use this amount to set a budget for housing. However, keep in mind that the bank is just guessing. Examine own your monthly budget and determine what you want to spend on a home.  If you are a prudent financial planner, you may decide that is is much less than what the bank tells you that you can afford.

2. Get A 15-Year Mortgage

When you calculate the differences between 15 and 30-year mortgages, a 15-year will involve higher monthly payments as there is greater amount allocated to the amortization component monthly, but the advantage is that you save on total interest over the life of the loan due to the shorter term and, usually, lower interest rate.   

Check out the best 15-Year Mortgage rates where you live now.

3. Set A Target Payoff Date

Take a look at BestCashCow’s online mortgage payment calculator to help you determine a goal for a payoff. Post reminders of the goal so that you can remember that you have a strong plan in place.

4. Start Automatic Payments

Most loan providers will allow you to set up automatic bi-weekly payments, but some may only do so for a fee. You can call your mortgage company to go over all of your payment options to see what works best. However, you will see that an automatic payment will be easier to deal with than trying to remember to send out a payment each month or every two weeks. 

5. Cut Expenses And Increase Earnings

Review your budget all the way through and try to cut expenses where you can, while also working to boost your earnings. This could be as simple as cutting out the use of your credit card, as those purchases can really add up and your finances take a blow because of it.