Buying a home is normally the largest financial decision one can undertake in life. In New Zealand in 2024, residential property prices were highest in the Auckland region, with an average price of around one million New Zealand dollars or around USD$611 thousand. (1)

Integral to home buying is the choice of a home loan structure. Think about all those decisions that will have a major impact on your financial future. This is definitely one of them! What you ought to do then is know exactly what options you have so you can make a proper decision.

Understanding different home loan structures

Let's dive into the most common types of home loans you'll encounter:

Fixed-rate mortgages

These loans come with stability in the form of constant interest rates throughout. So, if you lock up a rate of 3.5% on a 30-year fixed mortgage, that's what you'll pay for the entire course of three decades. This sort of predictability makes it easier to make budget estimations. But this can also leave one high and dry if the rates fall drastically.

Adjustable-rate mortgages (ARMs)

ARMs are all variations of an initial low interest rate that adjusts periodically. For instance, a 5/1 ARM keeps the original rate for five years, after which it changes once every year. That may be enough if you think you might want to move or avail of refinancing in a few years. However, it does carry the risk of going up in case the rates rise.

Interest-only loans

These are the types that allow you to pay interest only for a period, usually five to 10 years. The initial payments will be lower, but you'll be hit harder later when you actually start paying the principal. The possibility is they work well for borrowers anticipating their income to increase radically or those who hope to sell soon.

This type of loan is where working with a mortgage mentor becomes handy. They can help you structure your loan in a way that reduces your interest costs.

Balloon mortgages

These loans offer lower monthly payments for a set term, often five to seven years, followed by a large "balloon" payment of the remaining balance. They can be risky if you can't refinance or sell when the balloon payment comes due.

Factors to consider when choosing a loan structure

With an understanding of the home loan structures, consider these factors next:

Your financial situation

Take a hard look at your income, expenses, savings, and debts. Can you handle potentially higher payments with an ARM, or do you need the certainty of a fixed-rate loan?

Length of stay

If you're planning to move in a few years, an ARM might save you money. For your forever home, a fixed-rate mortgage could provide long-term stability.

Interest rate environment

In a low-rate environment, locking in a fixed rate can be smart. When rates are high, an ARM might make sense if you believe rates will decrease.

Risk tolerance

Are you comfortable with the possibility of your payments increasing, or do you prefer knowing exactly what you'll pay each month?

Future income projections

You absolutely can appreciate an ARM or interest-only loan, but only if you're early in your career and anticipate big bumps in salary.

Practical tips for choosing the right home loan structure

Want to make the right decision? Take heed of these tips:

Assess your long-term financial goals

Are you putting aside retirement money? Or, maybe you're hoping to start a business. You may be anticipating some major expenses like education costs. Your loan choice should align with these goals.

Calculate your debt-to-income ratio

Some 32% of applicants have been rejected for insufficient debt-to-income ratio in 2022. You can calculate yours by adding up your monthly debts and dividing by your gross monthly income. A high ratio would suggest you need a loan with lower initial payments. (2)

Consider your down payment amount

The bigger your down payment, the better the loan you can obtain and the better the rate you'll get. If you can't afford to make a large down payment, look for options with low down payments.

Evaluate your credit score

The higher the score, the better terms you'll have on your loan. If you have a score lower than 670, consider government-backed loans. Alternatively, work on improving your credit. (3)

Research and compare lenders

Don't just focus on your bank but shop around for at least three different offers from various lenders. Some terms and conditions may vary when comparing an online lender to a credit union or a traditional bank.

Understand the total cost of the loan

Look beyond the monthly payment. Take into account closing costs, mortgage insurance, and the total interest you'll pay over the life of the loan.

Consider potential life changes

May need to move for work? Starting a family soon? Select a loan that will allow for anticipated life changes.

Seek professional advice

A financial advisor, mortgage broker, or mortgage mentor can provide guidance specific to your very situation.

Common mistakes to avoid

Besides the above tips, make sure you avoid falling into these errors while opting for a mortgage loan:

Focusing solely on the interest rate

A low rate isn't everything. Consider the overall cost, including fees and mortgage insurance.

Neglecting to read the fine print

Understand all loan terms, including prepayment penalties or rate adjustment caps for ARMs.

Borrowing more than you can afford

Just because you qualify for a larger loan doesn't mean you should take it. Consider your other financial goals and lifestyle expenses.

Failing to consider future market conditions

If you're considering an ARM, think about how you'll manage if rates rise significantly.

Parting thoughts

An informed choice is one in which you know your options and consider all the factors relevant to you.

Never hesitate to make use of the variety of resources that are available, which are going to help arm you with the power to make optimum decisions, steering you financially toward long-term success.

Do not rush things; take time to research. Also, no hesitation in asking for professional advice if needed.

References:

1. "Average residential house price in New Zealand in March 2024, by region", Source: https://www.statista.com/statistics/1028580/new-zealand-median-house-prices-by-region/

2. "First-Time Homebuyer Facts and Statistics (2024)", Source: https://www.thisoldhouse.com/storage-organization/reviews/first-time-homebuyer-facts-and-statistics

3. "Is My Credit Score Good Enough for a Mortgage?", Source: https://www.investopedia.com/articles/personal-finance/081115/my-credit-score-good-enough-mortgage.asp#