Understand Mortgage Options

If you are going to purchase another home, it helps to understand what your mortgage options are.

If you are going to buy a home, you will probably need to get another mortgage. In this article, I want to give you some insight on a few mortgage programs and issues:

Fixed Rate
Adjustable Rate
Interest Only
Option ARM

I will also try to give you the advantages and disadvantages of each program.

Fixed Rate Mortgage
You’ve probably heard of the 30-year fixed rate mortgage. It is the most common type of loan. There are also 15-year (and even 10- and 20-year) fixed rate mortgages which allow you to pay off your mortgage in less time, with less interest. A fixed rate loan is one in which principal and interest are amortized, or spread out, evenly over the term of the loan, so that both interest rate and monthly payments remain unchanged for the life of the loan.

Fixed rate mortgages protect you from the risk of rising interest rates. If interest rates are particularly low when you purchase your new home, or if you expect them to rise, a fixed rate mortgage could be a wise investment. On the other hand, unlike adjustable rate mortgages (ARMs), fixed rate loans won’t take advantage of falling rates. Since you’re locked into one rate for the life of your loan, you could end up with interest higher than current market rates in the years to come. At that point, however, refinancing might enable you to take advantage those lower rates.

Adjustable Rate Mortgage
Adjustable Rate Mortgages (commonly called ARMs) are loans with interest rates and monthly payments that rise and fall with the economy. With an ARM, the borrower shares in the benefits and risks of having the loan tied to market changes. Because the borrower shares in the risk of rising rates, lenders are able to offer lower initial interest rates than on fixed rate mortgages. The interest rate on your loan is then adjusted periodically according to whatever market index you chose when selecting your ARM.

The most popular type of an ARM is known as a 2/28. With this loan, the payment remains the same for the first 2 years, then can adjust annually for each of the remaining 28 years.

Interest rate and monthly payment can change every six months, once a year, every three years, or every five years. For example, a one-year ARM has an adjustment period of one year, which means that the interest rate and monthly payment can change once a year. The frequency and dates of adjustments are established when you apply for your loan.

The interest rate on an adjustable mortgage changes according to a financial index. You may choose an ARM tied to any one of a variety of market indexes, such as CDs, T-Bills, or LIBOR rates. When your interest rate is up for adjustment, your lender will take the current rate of the index to which your loan is tied and add a margin, a certain set number of interest points laid out in your loan agreement, to determine your new rate. So, your interest rate and monthly payments could increase or decrease over the life of your loan, depending on the activities of the market.

Caps set forth in your loan agreement limit the amount by which the interest rate can increase at each adjustment. And ceilings, or lifetime caps, limit the total rate increase over the life of the loan. So, if you have a typical one-year ARM, your annual rate increases may be capped at 2%, which means that your interest rate can never increase by more than 2% over the previous year. Separately, your loan may have a lifetime rate cap of 6%. So, if you had an initial interest rate of 5%, the highest interest rate you could ever pay would be 11%. Caps protect you from drastic changes in interest rate, but do not guarantee you the stability of a fixed rate loan. With an ARM, you exchange the possibility of lower interest rates for the possible risk of rising rates.

An ARM might benefit you in several ways. ARMs usually come with initial interest rates that are 2-3 points lower than those on comparable fixed-rate mortgages. The lower initial interest rate can help you qualify more easily and afford the house you want to buy. You will most likely qualify for a larger loan with an ARM than with a fixed rate mortgage, although this can change if Congress imposes stricter lending standards on ARMs. In March of 2007, several sub-prime lenders went out of business partially due to homeowners being unable to absorb the higher payments on their ARMs.

You might also want to consider an ARM if you plan to move in a few years, so you are not concerned about the possibility of rate and payment increases. If you plan to move within 5 years, a 5-year ARM would even give you the advantages of a lower interest rate with none of the risks. And, even if you plan to live in your new home for longer, it might be safe to take the risks involved in an ARM if you expect your income to increase enough to cover potential increases in payments, or if you expect rates to fall.

Interest Only
An interest only mortgage lets you get the benefit of an infinite amortization period, meaning the lowest payments possible. In reality, there is not much of a difference in your payment between a 40 or 50 year mortgage and an interest-only mortgage. An interest only loan lets you make only the minimum interest payment on the loan without having to pay any principal. If you want to reduce your mortgage balance, you can also make additional payments to principal if you have the available cash.

Interest only loans are perfect for a homeowner who wants to take the extra cash and invest it to create an investment portfolio. Often, the portfolio will be higher than the principal that is not being paid off on the home. These loans are also perfect if you know that your home will rise in value at a fast rate and if you only plan on being in the home for less than 8 years. The amount of principal paid off in 8 years on a 30 year loan is fairly small.

Interest only loans eventually need to be paid back. Typically, after 10 years, you have to start paying back the principal on the loan.

Option ARM
An Option ARM is also known as a flex-pay loan. Each month, you have the option of making one of 4 payments – one based on a 15 year schedule, one based on a 30 year schedule, one based on interest-only and one based on a low start rate, often as low as 1%. Thus, on a $200,000 loan, you can make payments as low as $642 per month. each year, this minimum payment rises at about 7.5% per year, until it matches the interest-only payment.

There is one huge drawback with making the minimum payment. Each month that you do this, you incur deferred interest. This is the difference between what the interest-only payment would be at the stated rate and the minimum payment. This deferred interest is added to your loan balance. This is called negative amortization. If you only make the minimum payment, your loan balance will keep getting bigger. At some point the lender will then “recast” the loan, requiring you to make payments that would pay off the loan over the remaining 30 years. Remember, this is an ARM, and is subject to the same potential rate increases and decreases that a standard ARM has. Many homeowners have lost their homes to these kind of mortgages due to only being able to afford the minimum payment. These loans only make sense if you know you can make payments higher than the minimum, or if you are investing the cash difference or if your home will go up in value at a rate faster than the negative amortization.

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