There are many different mortgage products available today, and choosing the best one can be almost as challenging as finding the right house. This guide explains common types of mortgages to help you decide which one will best meet your financial needs. Before you get a mortgage, consider:
• what you can afford to pay each month based on your current income. (see Worksheet 1: How Much House Can You Afford?)
• whether you expect your income to rise, fall or stay the same over time.
• whether you plan to stay in the house longterm or move in a few years.
• your tolerance for risk.
• whether you expect interest rates to rise, fall or stay about the same.
TYPES OF MORTGAGES
Understanding the pros and cons of different types of mortgages is the first step in finding the loan that’s right for you. Here’s a look at the options available.
Fixed rate mortgages
With a fixed rate mortgage, the interest rate and monthly payments stay the same for the life of the loan.
These mortgages are usually fully amortizing, meaning that your payments combine interest and principal in such a way that the loan will be fully paid off in a specified number of years. A 30-year term is the most common, although if you want to build equity more quickly, you might opt for a 15- or 20-year term, which usually carries a lower interest rate. For homebuyers seeking the lowest possible monthly payment, 40- and 50-year terms are available with a higher interest rate.
Consider a fixed rate mortgage if you:
• are planning to stay in your home for several years.
• want the security of regular payments and an
unchanging interest rate.
• believe interest rates are likely to rise.
Adjustable rate mortgages (ARMs)
With an adjustable rate mortgage (ARM), theinterest rate changes periodically, and payments may go up or down accordingly. Adjustment periods on an ARM can vary, but it’s usually one year. All ARMs are tied to an index, which is anindependently published rate (such as those set by the Federal Reserve) that changes regularly to reflecteconomic conditions. Common indexes you’ll encounter include COFI (11th District Cost of Funds Index), LIBOR (London Interbank Offered Rate), MTA (12-month Treasury Average, also called MAT) and CMT (Constant Maturity Treasury). At each adjustment period, the lender adds a specified number of percentage points, called a margin, to determine the new interest rate on your mortgage. For example, if the index is at 5 percent and your ARM has a margin of 2.5 percent, your “fully indexed” rate would be 7.5 percent.
While you don’t need to understand the economic theory behind your mortgage’s index, you should ask your lender for a chart or graph of its historical rates so you get an idea of how quickly it can change. Mortgages that are tied to fast-moving indexes tend to have smaller margins, but your rate may change more frequently or drastically.
ARMs usually have caps that prevent the rate or payment from rising beyond a certain level between adjustment periods, as well as over the life of the loan. Typical rate caps might be 2 percent in any year, and 6 percent overall.
Using the cap information above as an example, if your initial interest rate is 4.5 percent, even if yourindex rate rose 2.5 percent, the highest your rate would rise to would be 6.5 percent. However, you don’t escape the rest of the rate increase; your rate would likely rise the other half percent immediately in the second year, to 7 percent. Over the life of your loan, your rate would not be able to rise to more than 10.5 percent.
ARMs usually offer a lower initial rate than fixed rate mortgages, and if interest rates remain steady or decrease, they may be less expensive over time.
However, if interest rates increase, you’ll be faced with higher monthly payments in the future.
Consider a traditional adjustable rate mortgage if you:
• are planning to be in your home for less than three years.
• want the lowest interest rate possible and are willing to tolerate some risk to achieve it.
• believe interest rates are likely to go down.
Also called “flex ARMs,” these are adjustable rate mortgages with a twist. Each month, rather than paying a set amount, you’ll receive a statement with up to four payment options, ranging from a small minimum to a fully amortized payment. You select the amount you want to pay each month.
Option ARMs entice borrowers by offering initial low minimum payments, but after an introductory period, the required minimum can rise substantially. In addition, if you choose the minimum payment, you won’t cover all the interest you owe for a payment period. This unpaid interest is added to your loan amount, meaning that even if you’ve made a payment, you could owe more on your loan, not less, than when your loan began. This is called negative amortization, and is something you should avoid.
Consider an option ARM if you:
• want flexibility because you have a fluctuating income – for example, if you’re self-employed or work on commission.
• are financially disciplined and won’t be tempted to simply pay the minimum every month.
Hybrid mortgages
A hybrid mortgage combines the features of fixed rate and adjustable rate loans. It starts off with a stable interest rate for several years, after which it converts to an ARM, with the rate being adjusted every year for the remaining life of the loan.
Hybrid mortgages are often referred to as 3/1 or 5/1, and so on. The first number is the length of the fixed term – usually three, five, seven or ten years.
The second is the adjustment interval that applies when the fixed term is over. So with a 7/1 hybrid, you pay a fixed rate of interest for seven years; after that, the interest rate will change annually.
Consider a hybrid mortgage if you:
• would like the peace of mind that comes with a consistent monthly payment for three or more years, with an interest rate that’s only slightly higher than an annually adjusted ARM.
• are planning to sell your home or refinance shortly after the fixed term is over.
Interest-only and balloon mortgages
Unlike an amortized mortgage where you pay a combination of interest and principal each month, with an interest-only mortgage you pay only interest for a fixed period – usually from five to 10 years.
This means the principal never goes down, and after this period has elapsed you have to either pay the entire principal off or start paying down the principal, which results in much higher monthly payments.
Balloon mortgages also offer low regular payments for a number of years (often just slightly below what you’d pay for a 30-year fixed rate mortgage). After this fixed period, the principal must be repaid as a lump sum, which generally means refinancing. Because very little of the principal has been paid down, once again, your payments will increase.
These loans can be helpful temporarily, but they don’t allow you to build equity in your home, and they can cause serious financial strain when the principal comes due.
Consider an interest-only or balloon mortgage if you:
• are buying a home with the expectation of an improvement in your financial situation – for example, you have a large debt that will be paid off in a few years.
• want to stay in your current home but are experiencing a temporary financial squeeze – for
example, you are going back to school, or taking a few years off to stay home with your children.
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