I was with a friend the other day, as we both went to an exhibit at the convention center. She stopped and wanted to ask a question about a friend of hers at work. It seems her friend was extremely studious about his money. He was a devout saver. She told me that he would literally buy a bucket of chicken and eat that for lunch throughout the work week. Instead of eating out for lunch, he saved his money to eventually buy a home instead. How much did he save? A little over $100,000 over the years. She told me he was going to make a nice down payment but then later on he was going to take the remaining amount and pay down the mortgage therefore reducing his monthly payment. She asked if that were the right strategy.
Of course, I didn’t personally know the situation nor him at all, just what my friend had told me. But I was able to give an answer. I asked if the loan he was going to get was a fixed or an adjustable. She of course didn’t know but I told her to give him some advice or even to feel free to contact me directly for a conversation. I gathered just from his frugal nature he would be taking out a fixed rate loan due to the continuing low rate environment.
From what I understood about his financial attitude, he wouldn’t want to take on the additional risk of rising interest rates at some unknown point in the future. It’s important to know in advance, especially if he hadn’t already bought a home and was waiting to make a sizable principal reduction, because making an extra payment down the road, at any time, has a different outcome depending upon if the loan taken out was a fixed or an adjustable mortgage. Why the difference?
When paying extra on an adjustable rate loan, it does in fact reduce the monthly payment because the new payment is calculated using the lower loan balance along with current market rates. But that doesn’t happen with a fixed rate loan. With a fixed, the payments remain the same throughout the life of the loan. Someone can have a 30 year fixed rate loan of say $400,000 with set monthly payments. It’s called a fixed rate for a reason, right? Okay, now what happens if that person makes a principal reduction of $100,000 and the loan drops below $300,000. Guess what? The payment remains at the original amount. Yes, the loan balance is reduced but the payments aren’t recalculated.
This is why it’s important to know whether or not an adjustable or fixed is better. Making extra payments is a good thing because it pays down the mortgage sooner. But if someone does have a plan to pay down the mortgage at some point in the future, perhaps an inheritance will ultimately arrive or maybe an annual bonus from work will be used to reduce the loan balance. With a fixed rate program, the payment is not affected. Just the balance.