With lower inflation and rising unemployment, the Federal Reserve seems poised to cut interest rates when the Federal Open Market Committee (FOMC) meets on Sept. 17-18.
Personal finance author and radio host Dave Ramsey has some thoughts for homebuyers and homeowners about the best way to set up a mortgage if they plan to take advantage of decreasing borrowing costs.
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After deciding on a home to purchase, Ramsey believes there is one financial decision that rises above all others when choosing a mortgage. And although he acknowledges some may be skeptical about whether they can afford it, Ramsey explains his advice on the best option.
The personal finance coach first clarifies the differences between a 15-year and a 30-year mortgage and then weighs in on his recommendations.
A 30-year mortgage allows for lower monthly payments, but will carry with it a higher interest rate on your loan. But since you'll be making payments over a longer period of time, the long-term effect will be paying your bank a significant amount more in interest.
The main challenge of a 15-year mortgage is that one's monthly principal-and-interest payments will be higher, perhaps as much as a third larger. But with a lower interest rate, a homebuyer will pay down the principal at a much quicker pace — and that will result in paying significantly less interest during the loan's life and a house that will be paid for in half the time.
Dave Ramsey explains why a 15-year mortgage is a homebuyer's best bet
Ramsey bluntly explains how a higher monthly payment on a mortgage is a better option in the long run.
The personal finance coach recommends a mortgage payment of equal to or less than 25% of one's monthly income. And that includes property taxes, insurance and homeowner association (HOA) fees.
In order to make this work financially, Ramsey has a stern warning: You will need to adjust your expectations on what type of house you are looking for. And the importance of saving for a larger down payment before purchasing the home comes into play in order to reduce monthly mortgage costs.
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Some people believe, Ramsey explains, that they should choose a 30-year loan and then simply make large payments on the principal as they are able. They believe they can pay off the mortgage in this fashion in 15 years anyway.
But Ramsey cautions that, in the real world and even with the best of intentions, this rarely occurs.
"Why? Because life happens instead," he wrote on Ramsey Solutions. "You might decide to keep that extra payment and take a vacation. Or maybe it's time to upgrade your kitchen. What about a new wardrobe? Whatever it is, there's always a reason to spend that money somewhere else."
With a 15-year mortgage locked in from the beginning, the temptation to spend money on unnecessary expenses simply isn't a viable option.
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Ramsey explains the importance of building equity in your home quickly
Equity in a real estate property like a home is:
- The value of the home.
- LESS the amount still owed on the mortgage.
That's why it's important to spend your money on the principal, rather than on interest rate payments.
"On the flip side, the smaller monthly payments of a 30-year mortgage will have you paying down the interest a lot slower," Ramsey wrote. "So, less of your monthly payment will go to the principal."
Related: Dave Ramsey has new strong words on buying a home and real estate
Ramsey clarifies that this approach leads to one fundamentally important way to build financial security — avoiding owing money.
"The shortest path to wealth is to avoid debt," Ramsey wrote. "And the best way to do that is to either buy a house with cash or go with a 15-year mortgage, which has the overall lowest total cost — and keeps borrowers on track to pay off their house fast."
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