Question: I’m beginning to research what it takes to buy a home (my first home). : I’ve begun to read a couple books that describe the fixed vs. variable : rate loans etc, etc, and I realize I need to clarify my understanding of : how various loans work. My father’s philosophy (he grew up during the : great depression) was simple. Never take a loan on anything and always : pay cash for everything. Don’t buy anything you can’t afford to pay for : yourself. He bought our very modest family home in the mid-west from my : grandmother in the early 1950’s. Well, unlike my father now I’m in 1994 : California and I’m going to need a loan to buy a home. : I guess I’ve inherited a bit of my father’s fear of loans however! I did : take a couple of loans for my college education which I paid off ASAP and : well before the full term of the loans. Also I do have a credit card but : pay it off every month to eliminate interest charges. I also bought a new : car last year and took a loan for $13,000. I’ve since paid $9,000 of this : loan and want to pay this off entirely ASAP. : I think I have a fair understanding of auto loans or maybe not? In my : mind I’ve begun comparing auto loans to home mortage loans in order to : clarify my understanding of the home mortage loan. In an auto loan, if : you say, pay off a four year loan in two years, isn’t the corresponding : interest reduced from that of four years to two years? But in a home loan : what Ive been reading and hearing from other people is that the majority : of interest is somehow crammed into the first couple years of the laon : and you don’t begin building equity in the home until the interst is paid : off first. Is this correct? Going back to the auto loan, the interest is : divided equally throughout the months of the loan term. Correct? But if : the auto loan is paid off early one saves paying the interest that would : be divided through the remainder of the normal loan period. Correct? : Of course I have’nt taken into account the various tax advantages allowed : when deducting interest on the home loan etc. I’m just trying to understand : the “architecture” so to speak of how the two loans are constructed. : Forgive my ignorance but if anyone can enlighten me on these questions I : would appreciate it!
Answer: If you have a Web browser, on http://www.homefair.com we have instructions to set up a mortgage spreadsheet, so you can see exactly how it works. Basically, each month the principal = last month’s principal plus interest minus your payment. Early in the mortgage, most of your payment goes to interest. Later on, it retires principal. You can always make an extra payment and reduce your balance.
Your choice of ARM vs. fixed rate should depend mostly on your likelihood of moving in the next 7 years or less. If that’s a high probability, then something shorter-term than 30-year fixed rate makes sense. Whatever loan you get, as your income rises you may want to make extra payments to reduce the balance. That would be consistent with your father’s philosophy and also good personal finance (unless after you take out your loan rates go up so that your mortgage rate is way below market)
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