Fixed Rate Mortgages
The traditional fixed rate mortgage is the most common type of loan programs, where monthly principal and interest payments never change during the life of the loan.
Adjustable Rate Mortgages (ARM)
Adjustable Rate Mortgages (ARM)’s are loans whose interest rate can vary during the loan’s term. These loans usually have a fixed interest rate for an initial period of time and then can adjust based on current market conditions.
Interest Only Mortgages
A mortgage is called “interest only” when its monthly payment does not include the repayment of principal for a certain period of time.
Components of an ARM
To understand an ARM, you must have a working knowledge of its components.
Commonly Used Indexes for ARMs
This is a list of the most commonly used indexes by ARM lenders.
Balloon mortgages have a note rate that is fixed for an initial period of time, and then the remaining principal balance is due at the end of the term.
Reverse Mortgage is a type of home equity loan that allows you to convert some of the equity in your home into cash while you retain home ownership.
What kind of loan program is a good fit for you?
So what kind of mortgage is a good fit for you? Fixed rate? Adjustable rate? The truth is, there is no one correct answer.
Fixed Rate Mortgages The traditional fixed rate mortgage is the most common type of loan programs, where monthly principal and interest payments never change during the life of the loan. Fixed rate mortgages are available in terms ranging from 10 to 30 years and can be paid off at any time without penalty. This type of mortgage is structured, or “amortized” so that it will be completely paid off by the end of the loan term. There are also “bi-weekly” mortgages, which shorten the loan by calling for half the monthly payment every two weeks. (Since there are 52 weeks in a year, you make 26 payments, or 13 “months” worth, every year.) Even though you have a fixed rate mortgage, your monthly payment may vary if you have an “impound account”. In
addition to the monthly loan payment, some lenders collect additional money each month (from folks who put less than 20% cash down when purchasing their home) for the prorated monthly cost of property taxes and homeowners insurance. The extra money is put in an impound account by the lender who uses it to pay the borrowers’ property taxes and homeowners insurance premium when they are due. If either the property tax or the insurance happens to change, the borrower’s monthly payment will be adjusted accordingly. However, the overall payments in a fixed rate mortgage are very stable and predictable.
Adjustable Rate Mortgages (ARM)’s are loans whose interest rate can vary during the loan’s term. These loans usually have a fixed interest rate for an initial period of time and then can adjust based on current market conditions. The initial rate on an ARM is lower than on a fixed rate mortgage which allows you to afford and hence purchase a more expensive home. Adjustable rate mortgages are usually amortized over a period of 30 years with the initial rate being fixed for anywhere from 1 month to 10 years. All ARM loans have a “margin” plus an “index.” Margins on loans range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property value. The index is the financial instrument that the ARM loan is tied to such as:
1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI).
When the time comes for the ARM to adjust, the margin will be added to the index and typically rounded to the nearest 1/8 of one percent to arrive at the new interest rate. That rate will then be fixed for the next adjustment period. This adjustment can occur every year, but there are factors limiting how much the rates can adjust. These factors are called “caps”. Suppose you had a “3/1 ARM” with an initial cap of 2%, a lifetime cap of 6%, and initial interest rate of 6.25%. The highest rate you could have in the fourth year would be 8.25%, and the highest rate you could have during the life of the loan would be 12.25%.
Some ARM loans have a conversion feature that would allow you to convert the loan from an adjustable rate to a fixed rate. There is a minimal charge to convert; however, the conversion rate is usually slightly higher than the market rate that the lender could provide you at that time by refinancing.
A mortgage is called “Interest Only” when its monthly payment does not include the repayment of principal for a certain period of time. Interest Only loans are offered on fixed rate or adjustable rate mortgages as wells as on option ARMs. At the end of the interest only period, the loan becomes fully amortized, thus resulting in greatly increased monthly payments. The new payment will
be larger than it would have been if it had been fully amortizing from the beginning. The longer the interest only period, the larger the new payment will be when the interest only period ends.
You won’t build equity during the interest-only term, but it could help you close on the home you want instead of settling for the home you can afford.
Since you’ll be qualified based on the interest-only payment and will likely refinance before the interest-only term expires anyway, it could be a way to effectively lease your dream home now and invest the principal portion of your payment elsewhere while realizing the tax advantages and appreciation that accompany home ownership.
As an example, if you borrow $250,000 at 6 percent, using a 30-year fixed-rate mortgage, your monthly payment would be $1,499. On the other hand, if you borrowed $250,000 at 6 percent, using a 30-year mortgage with a 5-year interest only payment plan, your monthly payment initially would be $1,250. This saves you $249 per month or $2,987 a year. However, when you reach year six, your monthly payments will jump to $1,611, or $361 more per month. Hopefully, your income will have jumped accordingly to support the higher payments or you have refinanced your loan by that time.
Mortgages with interest only payment options may save you money in the short-run, but they actually cost more over the 30-year term of the loan. However, most borrowers repay their mortgages well before the end of the full 30-year loan term.
Borrowers with sporadic incomes can benefit from interest-only mortgages. This is particularly the case if the mortgage is one that permits the borrower to pay more than interest-only. In this case, the borrower can pay interest-only during lean times and use bonuses or income spurts to pay down the principal.
To understand an ARM, you must have a working knowledge of its components. Those components are:
financial indicator that rises and falls, based primarily on economic fluctuations. It is usually an indicator and is therefore the basis of all future interest adjustments on the loan. Mortgage lenders currently use a variety of indexes.
Margin: A lender’s loan cost plus profit. The margin is added to the index to determine the interest rate because the index is the cost of funds and the margin in the lender’s cost of doing business plus profit.
Initial Interest: The rate during the initial period of the loan, which is sometimes lower than the note rate. This initial interest may be a teaser rate, an unusually low rate to entice buyers and allow them to more readily qualify for the loan.
Note Rate: The actual interest rate charged for a particular loan program.
Adjustment Period: The interval at which the interest is scheduled to change during the life of the loan (e.g. annually).
Interest Rate Caps: Limit placed on the up-and-down movement of the interest rate, specified per period adjustment and lifetime adjustment (e.g. a cap of 2 and 6 means 2% interest increase maximum per adjustment with a 6% interest increase maximum over the life of the loan).
Negative Amortization: Occurs when a payment is insufficient to cover the interest on a loan. The shortfall amount is added back onto the principal balance.
Convertibility: The option to change from an ARM to a fixed-rate loan. A conversion fee may be charged.
Carryover: Interest rate increases in excess of the amount allowed by the caps that can be applied at later interest rate adjustments (a component that most newer ARMs are deleting).
6-Month CD Rate
This index is the weekly average of secondary market interest rates on 6-month negotiable Certificates of Deposit. The interest rate on 6 month CD indexed ARM loans is usually adjusted every 6 months.
Index changes on a weekly basis and can be volatile.
This index is the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of 1 year. This index is used on the majority of ARM loans. With the traditional one year
adjustable rate mortgage loan, the interest rate is subject to change once each year. There are additional ARM loan programs available (Hybrid ARMs) for those that would like to take advantage of a low interest rate but would like a longer introductory period. The 3/1, 5/1, 7/1 and 10/1 ARM loans offer a fixed interest rate for a specified time (3,5,7,10 years) before they begin yearly adjustments. These programs will typically not have introductory rates as low as the one year ARM loan, however their rates are lower than the 30-year fixed mortgage. This index changes on a weekly basis and can be volatile.
This index is the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of 3 years. This index is used on 3/3 ARM loans. The interest rate is adjusted every 3 years on
such loans. This type of loan program is good for those who like fewer interest rate adjustments. The index changes on a weekly basis and can be volatile.
This index is the weekly average yield on U.S. Treasury securities adjusted to a constant maturity of 5 years. This index is used on 5/5 ARM loans. The interest rate is adjusted every 5 years on
such loans. This type of loan program is good for those who like fewer interest rate adjustments. This index changes on a weekly basis and can be volatile.
The prime rate is the rate that banks charge their most credit-worthy customers for loans. The Prime Rate, as reported by the Federal Reserve, is the prime rate charged by the majority of large
banks. When applying for a home equity loan, be sure to ask if the lender will be using its own prime rate, or the prime rate published by the Federal Reserve or the Wall Street Journal. This index usually changes in response to changes that the Federal Reserve makes to the Federal Funds and Discount Rates. Depending on economic conditions, this index can be volatile or not move for months at a time.
12 Moving Average of 1-year T-Bill
Twelve month moving average of the average monthly yield on U.S. Treasury securities (adjusted to a constant maturity of one year.). This index is sometimes used for ARM loans in lieu of the 1
year TCM rate. Since this index is a 12 month moving average, it is less volatile than the 1 year TCM rate. This index changes on a monthly basisand is not very volatile.
Cost of Funds Index (COFI) – National
This Index is the monthly median cost of funds: interest (dividends) paid or accrued on deposits, FHLB (Federal Home Loan Bank) advances and on other borrowed money during a month as
a percent of balances of deposits and borrowings at month end. The interest rate on Cost of Funds (COFI) indexed ARM loans is usually adjusted every 6 months. Index changes on a monthly basis and it not very volatile.
Cost of Funds Index (COFI) – 11th District
This index is the weighted-average interest rate paid by 11th Federal Home Loan Bank District savings institutions for savings and checking accounts, advances from the FHLB, and other sources of funds.
The 11th District represents the savings institutions (savings & loan associations and savings banks) headquartered in Arizona, California and Nevada. Since the largest part of the Cost Of
Funds index is interest paid on savings accounts, this index lags market interest rates in both uptrend and downtrend movements. As a result, ARMs tied to this index rise (and fall) more slowly than rates in general, which is good for you if rates are rising but not good for you if rates are falling.
L.I.B.O.R stands for the London Interbank Offered Rate, the interest rates that banks charge each other for overseas deposits of U.S. dollars. These rates are available in 1,3,6 and 12 month terms.
The index used and the source of the index will vary by lender. Common sources used are the Wall Street Journal and FannieMae. The interest rate on many LIBOR indexed ARM loans is adjusted every 6 months. This index changes on a daily/weekly basis and can be extremely volatile.
National Average Contract Mortgage Rate (NACR)
This index is the national average contract mortgage rate for the purchase of previously occupied homes by combined lenders. This index changes on a monthly basis and it not very volatile.
Balloon mortgages have a note rate that is fixed for an initial period of time, and then the remaining principal balance is due at the end of the term. When the final balloon payment is due at the
end of the term, the borrower can either refinance into another mortgage or pay off the balance. The balloon loans do not have any penalties for paying off the loan earlier than it is due. You would be able to refinance the loan at any time during the term. The two different terms a balloon loan can have are typically 5 or 7 years. For example if you had a 7 year balloon mortgage with an interest rate of 7.5%, your rate would remain constant for the full term and at the end of 7 years, the remaining principal balance would become due.
Reverse Mortgage is a type of home equity loan that allows you to convert some of the equity in your home into cash while you retain home ownership. Reverse Mortgage works much like traditional mortgages, only in reverse. Rather than making a payment to your lender each month, the lender pays you. Unlike conventional home equity loans, most Reverse Mortgages do not require any repayment of principal, interest, or servicing fees for as long as you live in your home. Funds obtained from an Reverse Mortgage may be used for any purpose, including meeting
housing expenses such as taxes, insurance, fuel, and maintenance costs.
To qualify for an Reverse Mortgage, you must own your home. The Reverse Mortgage funds may be paid to you in a lump sum, in monthly advances, through a line-of-credit, or in a combination of the three, depending on the type of Reverse Mortgage and the lender. The amount you are eligible to borrow generally is based on your age, the equity in your home, and the interest rate the lender is charging.
Because you retain title to your home with a Reverse Mortgage, you also remain responsible for taxes, repairs, and maintenance. Depending on the plan you select, your Reverse Mortgage
becomes due with interest either when you permanently move, sell your home, die, or reach the end of the pre-selected loan term. The lender does not take title to your home when you die, but your heirs must pay off the loan. The debt is usually repaid by refinancing the loan into a forward mortgage (if the heirs are eligible) or by using the proceeds from the sale of your home.
So what kind of mortgage is a good fit for you? Fixed rate? Adjustable rate? Government loans? The truth is, there is no one correct answer. Given the many different types of loans and term
lengths, the choice can be difficult. It is an extremely important choice and you can definitely benefit from research before you make your decision. Some time and effort right now can save you thousands of dollars in the long run. Your personal situation will determine the best kind of loan for you. By asking yourself a few questions, you can help narrow your search among the many options available and discover which loan suits you best:
- Do you expect your finances to change over the next few years?
- Are you planning to live in this home for a long period of time?
- Are you comfortable with the idea of a changing mortgage payment amount?
- Do you wish to be free of mortgage debt as your children approach college age or as you prepare for retirement?
Your lender can help you use your answers to questions such as these to decide which loan best fits your needs. Below is a general guideline that may be useful to consider when selecting the mortgage for your home:
Years you plan to stay in your home Plan to Consider
1-3 3/1 ARM or 1-year ARM
3-5 5/1 ARM
5-7 7/1 ARM
7-10 10/1 ARM or 30-year fixed
10+ 30-year fixed or 15-year fixed