Although you may see many different types advertised, they all belong to
just two families: those mortgages that carry fixed interest rates, and
those whose rates change during the course of the loan on a periodic
schedule mutually agreed upon by you and your lender.
Fixed Rate Mortgages
You are probably familiar with a fixed rate mortgage. Your parents
more than likely had one, as did their parents before them. The major
advantage of fixed rate mortgages is that they present predictable
housing costs for the life of the loan. Some fixed rate mortgages you
will probably hear about are:
- 30-Year Fixed Rate Mortgages
- 15-year Fixed Rate Mortgages
- Biweekly Mortgages
- "Convertible" Mortgages
When people thought of a mortgage 10 to 50 years ago, they thought of
a 30-year fixed rate mortgage. This traditional favorite is not the
only choice nowadays because volatile financial times created a whole
new range of selections. However, the 30-year fixed rate mortgage may
still be the best mortgage for your circumstances. It offers the lowest
monthly payments of fixed rate loans, while providing for a
never-changing monthly payment
schedule. Some lenders offers 25, 20, and even 40-year term mortgages as
well. But remember, the longer the term of the loan, the more total
interest you will pay.
The 15-year fixed rate mortgage allows homeowners to own their homes
free and clear in half the time and for less than half the total
interest costs of the traditional 30-year loan. The loan's term is
shortened by the 10 percent to 15 percent higher monthly payments. Some
homebuyers prefer this mortgage because it allows them to own their home
before their children start college. Others prefer it because they will
own their home free and clear
before retirement and probable declines in income. If you are
interesting in obtaining a 15-year fixed loan.
The major disadvantages or the 15-year fixed rate mortgage are the
sometimes higher monthly payments. But if saving on total interest costs
and cutting the time to free and clear ownership are important to you,
the 15-year fixed rate mortgage is a good option.
The biweekly mortgage shortens the loan term to 18 to 19 years by requiring a payment for half the monthly amount every two weeks. The biweekly payments
increase the annual amount paid by about 8 percent and in effect pay 13
monthly payments (26 biweekly payments) per year. The shortened loan
term decreases the total interest costs substantially. The interest
for the biweekly mortgage are decreased even farther, however, by the
application of each payment to the principal upon which the interest is
calculated every 14 days. By nibbling away at the principal faster, the
homeowner saves additional interest. Remember, however, that you trade
lower total interest costs for fewer mortgage interest deductions
on your federal income tax. Your ability to qualify for this type of
loan is based on a 30-year term, and most lenders who offer this
mortgage will allow the homebuyer to convert to a more traditional
30-year loan without penalty. Availability is limited on this mortgage,
but it can be worth looking for.
Mortgages That Change
Some newer mortgages afford homebuyers some the best qualities of the
fixed rate and adjustable rate mortgages. One new type of loan, often
called a Two-Step, Super Seven, or Premier Mortgage, gives homeowners
the predictability of a fixed rate and adjustable rate mortgage for a
certain time, most often seven or 10 years, and then the interest rate
is adjusted to fit market conditions at that time. The main advantage
associated with this type
of loan is that homebuyers often get a slightly lower than market rate
to begin with. The main disadvantage is that they may see their interest
rate go up by as much as six percentage points at the end of the
seven-year period. The lender may also reserve the option to call the
loan due with 30 days notice at that time, making this loan similar to a
balloon mortgage in some cases.
Lenders offer this type of loan in part because research indicates
that many homebuyers remain in the home for seven to 10 years before
moving. For this type of homebuyer, the Two-Step or Super Seven loan
present an excellent way of getting a fixed rate loan at a better than
market price for a fixed period of time.
Another type of mortgage that is becoming popular is called a Lender
Buydown, where the homebuyer gets an initially discounted rate and
gradually increases to an agreed-upon fixed rate over a matter of three
years. For example: When the market rate is 10 percent, the fixed rate
for the mortgage is set at about 10.5 percent, but the homebuyer makes
monthly payments based on a first year rate of 8.5 percent. The second
year the rate goes up to
9.5 percent, and for the third year through the remaining life of the
loan, the rate is calculated at 10.5 percent. A second type of lender
buy-down, called a Compressed Buydown, works the same way, but with the
interest rate changing every six months instead of on a yearly basis.
The Lender Buydown gives consumers the advantage of lower initial
monthly payments for the first two years of the loan when extra money
may be needed for furnishings and, secondly, the advantage of knowing
that, although the interest rate does change during the first three
years of the loan, the interest is fixed from the third year on.
Convertible mortgages offer today's homebuyer the option to change
the loan's interest rate after some period of time or some specified
movement in interest rates.
Convertible fixed rate mortgages are often referred to as the
Reduction Option Loan (ROL) or, in some locations, the Reducing Interest
Loan (RIL), or Mortgage (RIM). This new type of loan offers homeowners
the option of getting a loan that , under the right conditions, can be
adjusted to a lower interest rate with a payment of $100 or $200 or so
and a small loan amount-based fee, sometimes as little as one-fourth of a
percentage point. These
conditions usually are a prescribed movement in rates-typically two
percent below the initial- during a set time limit-between months 13 and
59, for example.
On a 30-year fixed rate mortgage with a reduction option, the
homebuyer pays an extra one-fourth to three-eighths of a percentage
point in the interest rate on the mortgage plus a quarter to
three-eighths of 1 percent of the loan amount (points) at the time of
closing. This allows the homeowners to adjust the interest rate on the
loan without having to go through a refinancing, which could cost up to 5
percent or 6 percent of the loan amount,
if the rates are right during the prescribed time limit.
On an $80,000 loan, this means that you could reduce the interest
rate on your loan from, say, 10.5 percent to 8.5 percent, and take
advantage of the low rates for the rest of the loan term for $150
instead of up to $4,800, if the rates dropped to that point during your
"window of opportunity" - months 13 through 59. Some homeowners may find
the ROL a good "insurance policy" against the high costs of
refinancing. Others may
want the flexibility that refinancing offers - namely the ability to
draw on built-up equity- that is not available with ROLs. The decision
is up to you.
Convertible Adjustable Rate Mortgages (ARMs) are another new loan
product on today's market. It works like any other ARM, but offers
homeowners a distinct advantage - it allows them to turn their ARM into a
fixed rate mortgage after a set period (usually during the second
through fifth years of the loan).
Adjustable Rate Mortgages
Adjustable Rate Mortgages (ARMs) have become on of the most popular
and effective tools for helping some prospective homebuyers achieve
their dream of homeownership. Developed during a time of high interest
rates that kept many people out of the housing market, the ARM offers
lower initial rates by sharing the future risk of higher rates between
borrower and lender.
ARMs can be an excellent choice of financing under certain
conditions, such as rising income expectations, high interest rates, and
short-term homeownership. But because payments and interest rates can
increase, either steadily or irregularly, homebuyers considering this
kind of mortgage need to have the income to keep up with all possible
rate and/or payment changes. Each ARM has four basic components:
- Initial interest rate, which is
typically one to three percentage points lower than that of most fixed
rate mortgages. Lower interest rates also make ARMs somewhat easier to
qualify for. The initial interest rate is tied to certain economic
indicators that dictate in part what the monthly payments will be.
- Adjustment interval, at the time between changes in the interest rate and/or monthly payment will be.
- Index*, against which lenders
measure the difference between what they are making on their investment
in the mortgage and what they could be making on other types of
- Margin, or the additional amount
the lender adds to the index to establish the adjusted interest rate on
an ARM. The margin is usually 1.5 percent to 2.5 percent.
In addition to the four basic components, an ARM usually contains
certain consumer safeguards such as interest rate caps, which limit the
amount that the interest rate applied to the payments may move. This
prevents the amount of interest the consumer pays from rising higher
than perhaps the homeowner can afford. For instance, a typical ARM would
have a two percentage point cap over the life of the loan. That means
that a loan with an initial
interest rate of 9.75 percent would be able to go no higher than 14.75
percent over the life of the loan, and it would be able to move no more
than two percentage points per year.
Another safeguard found on some ARMs are monthly payment caps that
limit the amount homeowners need to increase their payments at
adjustment time. Monthly payment caps can, however, sometimes prevent
the monthly payments from increasing enough to keep up with the rise in
the interest rate, causing negative amortization-resulting in higher or
more payments for the homeowner later on.
Other options you should ask about when shopping for an ARM are:
- Assumability, or whether you may transfer the mortgage to a new
homebuyer, usually with the same terms if the new homebuyer qualifies
for the loan. ARMs are almost always assumable.
- Convertibility allows the borrower to change an ARM to a fixed rate
mortgage, usually at the end of some predetermined period, locking in a
lower interest rate.