A Risk-Based Approach to Choosing Your Mortgage

The Motley Fool, Fidelity Investment, J.D. Edwards—all those big names and every other financial advisor always tell you to determine our threshold of risk before entering into investing. You should use a similar approach it comes to buying a house. Why not? Isn’t this the biggest investment you’ll ever make? More realistically, a house is probably the most expensive thing you ever buy and let’s face it a mortgage is a bit of a gamble. So before you choose a mortgage, get some insight into your personal risk tolerance.

The primary risk measurements are payment and equity.  You can measure your level of payment risk, by comparing mortgage options.

Adjustable mortgages, or ARMs, received a lot of bad PR over the past two years. But like most things, it’s not the instrument that causes harm, but how it is used that is dangerous. Many people were talked in to ARMs because the offered a way to purchase a home at lower monthly payments—usually a home that was above their means. The low rates of ARMs usually come with limited terms: most commonly 1, 5, or 7 years. After that, they “adjust” to market rates, which often mean a jump in payments. Many people didn’t understand what they were in for or chose to ignore this fact. That’s how borrowers got into trouble—they didn’t have the risk-tolerance. ARMs work well in many situations, these weren’t the right situations.

The result was that ARMs were considered bad guys and the conservative 30-year fixed mortgage—which is perfect for some people, but not for others—soon become the mortgage hero.

In reality, the 30-year fixed mortgage best fits the buyer who has a low tolerance for risk. You might be more comfortable with a fixed-rate mortgage if:

  • You tend to save with guaranteed accounts: certificates, 401(k), IRA, and
  • you expect to be in your home for more than 10 years.

The ARM is for buyers who:

  • Plan to move before the limit expires,
  • diligently watch rates
  • and/or plan to refinance before the rate expires.

The second part of the mortgage risk-tolerance assessment looks at equity.

Home equity is a product of the rate at which the market price of a home appreciates or depreciates and the remaining principal balance of a mortgage.

The type of mortgage you choose can impact your home’s equity. Your goal should be to build equity. Equity builds wealth and opens up additional financial benefits and financing options.

Typically, part of each month’s mortgage payment is applied toward the principal balance. However, if the principal balance of a mortgage remains constant or increases, home equity can be flat or reduced. Neither of these is good.

Because home equity plays an important role in future financing considerations, the rate of home equity creation should be a major part of any mortgage decision. This is especially true for interest-only and negative-amortization mortgages because most borrowers choose these loans with the intent to refinance out of them within a certain time horizon.

Using a risk-tolerance approach to home financing will help you understand the pros and cons of various mortgage programs and help you decide which is best for you.

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