Choosing A Mortgage
While there seem to be hundreds of different mortgages available, they all fall into a few basic categories. Some may fit your needs well, while other programs may be unwise or unattainable. It’s important to realize that the best product depends on where you are in your life. The best choice is the loan program that best fits your needs at the time you purchase a home.
In recent years, lenders have developed a greater variety of loan programs, mainly because they have found that homebuyers have a variety of different needs. First Time buyers, families "moving up" into larger homes as they need more space, or moving into smaller homes after children have gone on to start their own families; all have different needs. There are so many different individual loan programs available that to compare them all would be impossible. The following provides brief descriptions of the most common categories of mortgage loans.
Fixed Rate Mortgages
Fixed-rate mortgages are the most popular type of mortgage. With this mortgage, the interest rate will remain the same for the entire term of the loan. Typically, the longer the term of the mortgage, the more interest is paid over the life of the loan.
Thirty-year fixed rate loans are what most people think of when they hear the word "mortgage." Fixed rate loans are also referred to as "fully-amortized" loans. One of the aspects that buyers like about fixed rate loans is that the payments stay the same for the life of the loan. Generally, these loans are offered in a 15- or 30-year duration.
A 30-year loan will provide larger tax deductions, as you will be paying more interest than principal during the first 23 years of the loan. A 15-year loan, on the other hand, is paid off twice as quickly and usually has a lower interest rate. You build more equity because your payments pay more principal. As mentioned earlier, you also can "buy down" your loan by paying more tax-deductible points up front, to lower your fixed interest rate.
Adjustable rate mortgages all have certain similar features. They have an adjustment period, an index, a margin, and a rate cap. The adjustment period is simply how often the rate changes. Some change monthly, some change every six months, and some only adjust once a year. An Adjustable-rate mortgage (ARM) is a mortgage in which the interest changes periodically according to corresponding fluctuations in an index. All ARMs are tied to indexes. Indexes are simply an easily monitored interest rate that moves up and down over time. Adjustable rate mortgages vary and are tied to different indexes.
Adjustable Rate Mortgages (ARMs) are attractive to many homebuyers for one reason: lower payments in the first years of the loan. Typically, an ARM will have a low introductory rate, sometimes called a "teaser" rate. This rate is usually much lower than the fixed rates available at that time.
Adjustable rate mortgages (ARMs) have payments that increase or decrease on a regular schedule, and are linked to specific economic indexes or margins. These indexes measure borrowing and lending costs throughout the United States and are independent of the lender and can be independently verified at any time. (Many ARMs are indexed to Treasury bills or securities, Certificates of Deposit and other rates.)
- How and When do ARMs Adjust? When comparing ARMs that have different indexes, look at how the index has performed recently. Some indexes are published in newspapers, making them easy to track. Lenders are required to provide you with information on how to track the index and a 15-year history of the index, but keep in mind that past performance is not necessarily indicative of future performance. An ARM will have a low Initial Interest Rate, sometimes called "teaser" rate. The loan will begin to adjust at a certain interval, usually every six months or annually. When the loan adjusts, the lender will use three things to determine the new interest rate: the index, the margin and the cap(s).
- Index The index is a benchmark by which changes in the market interest rates are gauged. Common indexes include the 1 Year T-bill, the 11th District Cost of Funds, Prime, LIBOR, or even Certificate of Deposit (CD) rates.
- Margin In order to determine the new rate on the adjustment date, the index is added to the margin. The easiest way to understand the margin is to put the word "profit" in front of it. It is the amount of excess of the index that the lender is going to charge in interest; it is essentially the lender’s profit margin.
- Rate Caps To insure that your payments do not change dramatically in any given six-month or one-year period, adjustable rate mortgages provide protection in the form of interest rate caps. There are two kinds of interest rate caps: periodic (annual, semi-annual, etc.) and lifetime. For example, a loan may have a semi-annual rate cap of 1%, or an annual rate cap of 2%. The loan will also have a lifetime rate cap, frequently 6% over the initial rate. The caps insure that even if interest rates rise rapidly, the monthly mortgage payment will not be as dramatically affected.
- Is an ARM for You? Would you like a loan with an interest rate below a 30-year fixed rate mortgage and pay zero points? A loan for which you do not have to document your income, savings history or source of down payment? These benefits can all be possible with an Adjustable Rate Mortgage. There are numerous advantages to ARM loans. Some common advantages are:
- The ability for borrowers to qualify when they might not do so with a fixed rate mortgage;
- The possibility of obtaining a larger loan and a more expensive home;
- The chance that the rates may go down without refinancing; and,
- Often, there are less costs to obtain the loan.
However, with an ARM, there is the likelihood that your rate and payment will increase during the life of the loan. Adjustable Rate Mortgages all have an adjustment period, an index, a margin and a rate cap. The "adjustment period" simply indicates how often the rate changes. Some rates change monthly, some change every six month, and some only adjust once a year. Indexes are monitored interest rates over time. ARMS have different indexes. The margin does not change during the life of the loan.
This is a "traditional" mortgage, not directly insured by the Federal Government. Most conventional loans under $625,500 are administered through Fannie Mae or Freddie Mac (private corporations but regulated by the government). Loans greater than this amount are called "jumbo loans" and are funded by the private investment market.
These loans are insured by (but not funded by) the Federal Housing Administration (FHA) a division of the U.S. Department of Housing and Urban Development (HUD), and designed for, in general, low- to middle-income borrowers and many first time buyers. There are, however, limits to the maximum loan amount which will vary from county to county. FHA loans have somewhat more relaxed qualifying standards and ratios than conventional loans and have the availability of both 15 and 30 year fixed as well as 1 year adjustable mortgages.
For those qualified by military service, the Veteran’s Administration (VA) insures (but does not fund) 15 and 30 year fixed as well as 1 year adjustable mortgages with lower down payment requirements and somewhat more lenient qualifying ratios.
Low Down Payment Mortgages
Sometimes having enough funds for the down payment and closing costs as required by a basic fixed-rate mortgage is not achievable. There is an array of low down payment mortgages. These types of loans are designed for homebuyers' varying needs and take into account the many other factors that qualify the financial condition of the borrower. Some loans are designed for buyers with good credit histories, some offer more flexible qualifying requirements and may be helpful for limited incomes, and others balance a low down payment with a higher interest rate.
Some adjustable rate mortgages allow the interest rate to fluctuate independently of a required minimum payment. If a borrower makes the minimum payment it may not cover all of the interest that would normally be due at the current interest rate. In essence, the borrower is deferring the interest payment, which is why this plan is called "deferred interest." The deferred interest is added to the balance of the loan and the loan balance grows larger instead of smaller, which is called negative amortization.
Mortgage hybrids are a cross between a fixed rate and an adjustable-rate mortgage. They generally have fixed rates for the first three, five, seven or ten years and then they convert to adjustable-rate mortgages (ARMs) for the remainder of the loan term. With hybrid loans the fixed rate is established up front. Once the fixed-rate portion of the loan ends, the mortgage then behaves like an ARM with rate changes and monthly payments moving up and down each year as interest levels change. The attractiveness of these types of loans is that a borrower can sometimes find a 5/1 ARM rate at up to a full percentage point below a comparable fixed rate loan, and for several years the homeowner can benefit from a lower rate. Generally, the shorter the fixed-rate period, the better the up-front discount, the longer the fixed-rate period, the smaller the discount when compared to 30-year financing.
Loan Terms: 15, 20 or 30 Years
As the term of the loan (period over which the loan is paid) decreases, so does the amount of total interest paid. It is a good exercise to make a comparison between a 15 year term monthly payment and a 30 year term monthly payment. The monthly payment difference is often smaller than anticipated. The savings over the term of the loan, however, can be substantial. For example, comparing a 15 year term to a 30 year term, $100,000 mortgage at an 8.5% fixed rate yields the following:
If you cannot qualify for a shorter term loan, try to add at least the amount of 1 additional payment per year—this will take nearly 10 years off a 30 year loan.
Points or No Points
A large component of your mortgage decision has to do with one of the first charges associated with the loan. This is the "points" attached to the mortgage. A point is equal to 1% of the loan amount, and is paid to the lender or the mortgage broker at closing. Each loan product and buyer situation is different. You will need to understand your options and make the best decision based on your situation.
Rates go up as points go down. Here are some examples of monthly payments (principal and interest only):