Traditional Loans
Although you may see many different types advertised, they all
belong to two families: mortgages that carry fixed interest rates,
and those whose rate changes during the course of the loan, on
a periodic schedule mutually agreed upon by you and your lender.
Below we discuss the main features of fixed rate mortgages
and adjustable rate mortgages along with the advantages and disadvantages of each. This discussion is applicable to
New Jersey mortgage finance, New York mortgage finance and Pennsylvania mortgage finance.
The interest rate on fixed rate mortgages is fixed over the life of the loan and never changes.
Fixed rate mortgages are usually "fully amortizing" over the life of the loan. That means that the amount initally borrowed is completely paid back over the life of the loan.
The major advantage of fixed rate mortgages is that they provide predictable
housing costs. The montly loan payment never changes. Therefore, fixed rate mortgages are especially
attractive in a rising interest rate environment.
Your total monthly housing payment may increase even though you have a fixed rate mortgage. Since you pay
a portion of the annual property taxes and homeowners insurance every month, if those items
go up, so will your total monthly housing payment. The disadvantage to fixed rate mortgages is that the monthly payment is typically higher than
adjustable rate mortgages. Some fixed-rate mortgages
you will probably hear about are:
- 30 year fixed rate mortgages
- 20 year fixed rate mortgages
- 15 year fixed rate mortgages
The shorter the term of a fixed rate loan, the lower the interest rate. However,
because fixed rate loans are fully amortizing, the shorter the term, the higher the monthly payment is because the loan
principal is paid back at a faster rate. The 30 year fixed rate loan is the traditional favorite because it offers an
attractive combination of lower principal amortization payments as well as a fixed rate of interest. Some
lenders offer 10,25, and even 40-year term mortgages as well. Remember,
the longer the term of the loan, the more total interest you will
pay but the lower the monthly principal repayment.
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 fixed rate loan. The loan's
term is shortened by the 10 percent to 15 percent higher monthly
payments. Some home buyers prefer this mortgage because they will own their home free and clear before
retirement and probable declines in income.
Adjustable Rate Mortgages (ARMs) are one of the most popular
and effective tools for helping some prospective home buyers achieve
their dream of home ownership. 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. The interest rate is fixed for a initial period of time,
usually 1, 3 or 5 years. After the initial fixed period, the loan adjusts based on a formula agreed at the time of closing.
The frequency of adjustments is also specified in the original loan documents. Adjustable rate loans typically adjust every six months or every year.
The formula contains a margin that is added to a base index that is published regularly in the
financial press.
ARMs can be an excellent choice of financing. First, adjustable rate mortgages are attractive during
periods of declining interest rates or when rates are expected to stay low. In addition, if you only plan to stay in your home
for a limited period of time, it may be worth considering an adjustable rate mortgage to "match" the period of your expected ownership
with the fixed rate period on the loan.
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 , 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
investments. The most popular index is based on the rate of return
on a one- year Treasury bill (also called T-bill).
- Margin , 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.
It is the index plus the margin that will determine what the interest
rate will eventually be. Commonly used indexes include:
Treasury Bills. The weekly average yield
on U.S. Treasury securities adjusted to a constant maturity of
1 year. It is based on the interest rate that the government pays
on some of its debt. This index is used on the majority of ARM
loans.
Twelve Month Moving Average. Twelve month moving average of the average
monthly yield on U.S. Treasury securities (adjusted to a constant
maturity of one year. Because the index calculation
is an average of an average, it is less volatile.
Certificates of Deposit. The weekly average of secondary market interest
rates on 6-month negotiable certificates of deposit. They are
interest bearing bank investments that will lock your savings rate
in for a specific period of time. ARM loans tied to this index are usually tied to the average interest
rate banks are paying on 6-month CD's. Since this index is tied to bank CD's you can expect
this index to adjust a bit more slowly on rising interest rates.
They also tend to come down quickly when rates decline because
banks do not want to pay higher interest unnecessarily.
Cost of Funds Index. This index is also known as COFI (pronounced just like a cup of
coffee). It is published monthly by the Federal Home Loan Bank
Board. The index shows the monthly weighted average cost of savings,
borrowings, and advances, for member banks in California, Arizona,
and Nevada (the 11 th District). Because COFI is a moving average
of rates that bankers have paid depositors in recent months it
tends to be more stable. This means that the index will increase
more slowly when rates are going up. It will also decrease more
slowly when rates are going down.
Libor. This is the London Interbank Offered Rate index. It is an average
of the interest rates that major international banks charge each
other to borrow U.S. dollars in the London money market. These
rates are available in 1, 3, 6, and 12 month terms. The index used,
and the source of the index will vary by lender. Common sources
are the Wall Street Journal and Fannie Mae. The interest rate on
many LIBOR indexed ARM loans are adjusted every 6 months.
Margin. The margin is the markup that lenders charge on the money they
are lending. It is usually somewhere around 2.75%. The margin does
not change during the life of the loan. If your lender offers you
various margins, you should consider the lower margin since it
will have an impact on how much your rate will increase during
the loan term. It is the index plus the margin that gives you the
fully indexed rate. This is the rate that your loan should actually
be at according to current market conditions.
Adjustments. It is important to find out how often the particular adjustable rate mortgage loan
you are looking at will adjust. Adjustments are usually every 6
or 12 months. The lender must inform you before your interest rate is about
to adjust. There are usually limits built into the loan as to how
much the rate can increase at any one time. These limits are known
as periodic rate caps. When shopping for an ARM loan always find
out how often the loan will adjust, and what the interest rate
caps are.
Periodic Adjustable Rate Cap. There are two types of rate caps. There is the periodic adjustment
cap and the lifetime cap. The periodic adjustable rate cap limits
the maximum rate change, up or down, allowed for each adjustment.
If your ARM adjusts every 6 months, the periodic cap is usually
1% (one percentage point above your current rate). If your ARM
adjusts every 12 months the periodic cap is usually 2%.
Lifetime Cap.
You should never take an ARM without a lifetime cap. This cap
limits the maximum amount the interest rate can adjust over the
life of the loan. ARM loans usually have a lifetime cap of 5% to
6% above the start rate of the loan. When deciding on an ARM loan
always figure your payment at the maximum rate. This way you will
know in advance the very worst-case interest rate for your loan.
Some loans offer artifically low monthly payments for a period of time.
If the monthly payment is less than the amount of the interest that accrues on the loan during the month,
the difference will be added to the principal balance of the loan. This is called negative
amortized loan. It means that your mortgage loan is getting BIGGER with time, not smaller.
This type of loan does have some benefits. It is usually easier
to qualify for and can help out buyers who are having problems
qualifying at the standard 30 year fixed rate. It also usually
offers the borrower an option on how they wish to pay the loan
off each month. They can pay the fully amortized payment, and not
allow the loan to go into negative amortization. They can pay the
full interest only payment, which does not pay the mortgage down
but also does not add to the mortgage balance. They can pay the
fully amortized payment for a 15-year loan and pay the balance
in full in 15 years. They can also pay the smallest payment allowed
which is at the payment cap and allows the loan balance to increase.
If your negative amortization loan has this feature, you can usually
choose each month which payment option you want to take. This can
often make this type of loan very flexible. It is important to
remember though, that if you are the type of borrower who will
more then likely always pay the minimum due each month, this type
of loan is probably not for you.
Conventional Loans
The term conventional loan refers to loans that are not sponsored by government programs such as FHA loans and VA loans. Conventional loans are both fixed rate and adjustable rate and
come with a variety of features. Two government sponsored entities, Fannie Mae and Freddie Mac, buy and sell conventional loans from lenders and
provide vitally needed funds available for prospective home buyers to complete their home purchase at reasonable interest rates. There are limits to the size of
loans that fannie mae and freddie mac can purchase. Conforming loans are loans are loans that are less than the fannie mae and freddie mac loan limits. Jumbo loans are
loans that exceed those limits. As a result, capital available for jumbo loans is not as robust as that for conforming loan. This is why jumbo loans
come at higher interest rates than conforming loans.
Interest Only Loans
Interest only mortgages are designed to minimize the required monthly payment. They require that the borrower pay only the interest th
accrued during the month and no prinicipal amortization payment. This can significantly reduce the required on a mortgage. For example, the interest only payment on a 30 year mortgage
in the amount of $300,000 at a note rate of 5.0% would be $1,250 compared to a full amortizing payment of $1,610. the interest only period is usually for initial term (usually 3 to 5 years) at the
beginning of the loan. After the initial interest only period, the loan becomes fully amortizing over its remaining life. At that point, the minimum payment increases significantly. In the
above example, assuming the interest only period was 5 years, the monthly payment would increase to $1,754 over the remaining 25 years.
If the borrower did not want to bear the higher payment, he would need to refinance the loan. Interest only loans are reserved
for home buyers who put down more than 10%. In addition, lenders typically reserve these loans for those with very strong credit reports and credit scores.
Prepayment Penalty
Some lenders offer loans which limit your right to payoff the loan for a period of time in exchange for a lower interest rate. These so called "prepayment penalties" typically
cause the borrower to pay an extra amount of money above the loan principal to pay off the loan. Prepayment penalties come in various
forms. For example, some prepayment penalties apply in the event that you are keeping the house but just refinacing the
mortgage. These are referred to as "soft" prepayment penalties. Prepayment penalties that are triggered even in the event that the home is sold are
referred to as "hard" prepayment penalties. The period of time that prepayment penalties are in effect vary but typically they
last between 1 and 5 years. The amount of the penalty varies as well. It is not unusual for a prepayment penalty to be as high as
2% of the remaining loan amount.
Mortgage Insurance
In situations where the borrower applies for a loan that is greater than 80% of the purchase price (in otherwords, he makes a downpayment
of less than 20% of the purchase price), the lender will require that he pay for mortgage insurance. Mortgage insurance provides financial protection to the
lender in the event that the lender is required to foreclose on the loan. Mortgage insurance would reimburse the lender if the property for losses sustained in the
event that the property sells for less than the amount of the mortgage it secures at the foreclosure sale.
The cost of mortgage insurance varies by loan type, property type and the amount of downpayment. The premium can be as much as 1.0% of the loan amount annually. In addition,
mortgage insurance premiums are not tax deductible like interest payments.
In some cases, it may be possible to avoid paying mortgage insurance by structuring the purchase with two loans. The first mortgage
is done at 80% of the purchase price and the second mortgage is down for the balance of the required proceeds. Such loans are referred to
as "80/10/10" loans (the 80 refers to the percent of the first mortgage of the purchase price, the 10 refers to the percent of the second
mortgage of the purchase price and the remaining 10 refers to the amount of the downpayment as a percent
of the purchase price). In most cases, the second mortgage is a home equity line tied to the prime rate. These types of structures also exist in
80/15/5 and 80/20/0. Usually, structuring a purchase in this manner can save the borrower a significant amount of money
in mortgage insurance premiums. However, is typically assuming interest rate risk since the interest rate on the
home equity loan typically adjusts monthly with the prime rate.
The Federal Housing Administration (FHA) and the Veterans Administration
(VA) offer a wide range of mortgage choices that may appeal to
you. These include 30 fixed and 15 fixed rate mortgages, as well
as ARMs. Insured by these government agencies, the loans feature
low or no down payment terms and are often assumable by future
purchasers. VA loans are restricted to individuals qualified by
military service or other entitlements, but FHA loans
are open to all qualified home purchasers. Note that there are
limits to handle moderate-priced homes anywhere in the country. Select the No Money Down Loans link above for more information about
VA loans and FHA loans.
One important method is by bearing in mind that mortgage packages
consist of more than interest rates. They consist of a quoted rate,
plus discount points (pre-paid interest assessed by the lender
at settlement, or the meeting when the property legally changes
hands) and other fees, plus a full range of terms including adjustable
versus fixed-rates, low downpayment versus high downpayment,
the presence or absence of prepayment penalties, and many other
features noted earlier in this brochure.
When you call around to different mortgage lenders, you might
find one lender quoting you an interest rate of 6.0% for a 30 year
fixed rate, while another lender quotes you a rate of 5.0%. If
you automatically jump at the lower rate of the two, it could end
up costing a lot more money.
Remember, an interest rate quote always goes along with points
to be paid on the loan. A lender can quote you varying interest
rates, and almost always the lower rate has the higher points.
Points are charged by the lender as a way to buydown the rate on the mortgage loan. When comparing
rates it is always important to also calculate the points involved.
A point is 1% of the loan amount. So
if your loan is $200,000 one point would be $2,000. Let's say the
interest rate of 5.0% is for a one point loan or $2,000. Maybe the
points for the 6.0% loan are 0.50% or $1,000. You will then be
paying $1,000 more in points for the lower rate. If the difference
in payment is $189 per month, how long will it take to make up
for paying the extra $1,000? If you divide $1,000 (the difference in
the cost of the points) by $189 (the monthly savings) you will
get 5.29. It will take 5.29 months to break even. After that,
you will actually be saving money. If you plan on keeping this
house for a long period of time and staying in this mortgage you
will be saving a lot of money over the life of the loan. After
the first 5.29 months you will save $2,268 per year if you take
the lower interest rate.
One way to evaluate rates is by examining the Annual
Percentage Rate (APR) . The APR can help you compare
different types of mortgages. It indicates the "effective rate
of interest" paid per year. The figure includes discount points
and other charges and spreads them out over the life of the loan.
By law, the APR must always be disclosed to you within three days
after applying for a loan. The APR is the effective interest rate
for loans that are repaid over their full term. The APR calculation
assumes you will be keeping your loan for its full term. However,
most people sell or refinance their loan within 6 to 12 years. If you sell or refinance
the loan, the value of paying points is diminished dramatically. Similarly, paying points usually
does not make sense since once the fixed period is over, the rate will adjust to the fully indexed rate.
In addition, it is not likely to make financial sense to pay points on a 15 year (or shorter term) loans that are fully
amortizing. On short(er) term fully amortizing loans, a significant component of the monthly payment involves paying back borrowed
principal. This money will not be lowered by paying points and therefore the savings potential of paying points is diminished.
While the APR provides you with a common point for comparison,
look at the whole product before deciding which mortgage to get.
Pick the one with the rate, payment schedule and other terms that
suit your situation best.
To compare costs when shopping for loans ask lenders to quote
a rate based on the same points (a one-point loan is good for comparison).
That way you can generally see which lender has the better rate.
Don't forget to compare the APR also, to ensure the lender with
the better rate/point quote isn't adding on additional fees. Always
ask a lender whose loan you are considering to provide you with
an estimated breakdown of closing costs. That way you can compare
more accurately.
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