Finding a mortgage can be a strenuous process. Not only are there hundreds
of institutions offering mortgages, it can seem as though there are dozens of
different types. Different interest rates, different lengths and other
features can be confusing. This article describes some of the different
options you may encounter as you shop for a mortgage. As you review your
options, keep two thoughts in mind:
- How long do you expect to live in the home?
- What is your tolerance for monthly payments increasing?
Fixed Rate Mortgages
As the name implies, with a fixed rate mortgage, the interest rate
is set at the time you take out the mortgage and remains constant over the
life of the mortgage. The monthly payment level also remains constant.
Knowing what your payment will be can be reassuring.
Each monthly payment is comprised of interest and principal with early
year payments being primarily interest and payments toward the end of the
mortgage being mostly principal. Most of the mortgage pay down comes late in
the mortgage period.
Most institutions offer fixed rate mortgages of 30 years and 15 years. The
benefit of the shorter 15-year mortgage is that after 15 years you will have
paid off the mortgage loan and you own your home free and clear. You will
also pay less interest over the life of the mortgage. The negative is that
your monthly payments will be higher.
Comparing a 15-
year mortgage and a 30-year mortgage |
|
15-year
mortgage |
30-year
mortgage |
| Mortgage amount |
$150,000 |
$150,000 |
| Interest rate |
6% |
6% |
| Monthly payments |
$1265.79 |
$899.33 |
| Total monthly payments over the term of
the mortgage |
$227,840.88 |
$323,754.89 |
| Total principal paid over the term of
the mortgage |
$150,000.00 |
$
150,000.00 |
| Total interest paid over the
term of the mortgage |
$77,840.88 |
$173,754.89 |
Choosing the term of a fixed rate mortgage is usually a function of what
level of monthly payments you can afford and how anxious you are to pay off
the entire mortgage.
Adjustable Rate Mortgages (ARMs)
With an adjustable rate mortgage, the interest rate and monthly
payments can change as interest rates change. The rate is fixed initially and
is subject to being reset based on changes in some interest rate benchmark.
The big benefit to the borrower is that usually ARMs have interest rates (at
least initially) that are lower than the rates on fixed rate mortgages.
Sometimes it can even be 1½ to 2½ % less.
There are several features of ARMs that you should evaluate if you are
considering this type of mortgage.
- Initial Rate. Be careful if the initial rate seems real low. It could
be a "teaser" rate that only lasts for a short time and then the
rate is adjusted upward. At a minimum, ask what the rate would be adjusted to
if the initial rate ended today.
- Benchmark the ARM is pegged to. ARM rates are usually tied to some
"published" index that reflects the general interest rate market.
Usually the ARM rate is adjusted to that benchmark plus some level of margin.
Ask the lender how this works and try to get an understanding of how the
benchmark rate has changed recently.
- The cap. Most ARMs have limits on how much the rate can rise in any one
year and some ARMs have a limit to what the rate can rise to over the course
of the mortgage. Understanding how the caps work will let you know the "worst case scenario" if rates rise substantially.
- Length of the rate periods. When you look at ARMs you may find there
are terms like 3/1, 5/1, 7/1, 10/1 and the like. These refer to how long the
initial rate lasts and how often the rate is adjusted after that.
Adjustable rate mortgages are attractive because of their lower initial
rate. Your risk is that your rate and monthly payment will rise in the
future. If you are comfortable that you can accept an increased payment or if
you think you will be moving in a relatively short time, the savings with an
ARM can be substantial.
Other Issues
Negative amortization. Amortization refers to the process of paying
down a mortgage. Some lenders offer mortgages with lower monthly payments
than what is needed to pay interest and ultimately pay off the mortgage. This
means the amount due on your mortgage increases over time as interest that was not covered in the payment is added to the balance of your loan. This type of mortgage may be appropriate for borrowers with fluctuating income. It is important to have a good understanding of this product prior to making this choice.
Balloon mortgages. Balloon mortgages are similar to fixed rate mortgages
with steady monthly payments using a 15 or 30 amortization. However, with a
balloon, the mortgage comes due before 15 or 30 years. Most balloon mortgages
are for 3 to 7 years. They usually offer lower interest rates than the
traditional 15 or 30 year fixed rate mortgage. But, remember that with a
balloon, your mortgage will be due on a given date. This product works well for borrowers who plan to refinance or sell their property prior to the balloon payment.
