Fixed Rate vs. Adjustable Rate Mortgages
All mortgages can be divided into two main conventional and government loans. Additionally, each of the various mortgage programs can further be classified as fixed rate loans, adjustable rate loans, or a combination of the two.
Fixed Rate Mortgages With fixed rate mortgage (FRM) loans, the interest rate and monthly payments remain fixed for the period of the loan. Fixed-rate mortgages are available for 40, 30, 25, 20, 15, and 10 years. Generally, the shorter the term of a loan, the lower the interest rate. The most popular mortgage terms are 30 and 15 years. With the traditional 30-year fixed rate mortgage, monthly payments are lower than they would be on a shorter term loan. But if a borrower can afford higher monthly payments, a 15-year fixed-rate mortgage allows repayment twice as fast and saves more than half the total interest costs of a 30-year loan. The payments on fixed rate fully amortizing loans are calculated so that at the end of the term the mortgage loan is paid in full. During the early amortization period, a large percentage of the monthly payment is used for paying the interest. As the loan is paid down, more of the monthly payment is applied to principal. With bi-weekly mortgage plans, a borrower pays half of the monthly mortgage payment every two weeks. Because of the extra principal paid each year, the loan is repaid in less time. For example, a 30 year loan can be paid off within 21–23 years.
Adjustable Rate Mortgages A variable or adjustable rate loan is a loan whose interest rate, and therefore monthly payments, fluctuate over the period of the loan. With this type of mortgage, periodic adjustments based on changes in a defined index are made to the interest rate. The index for a particular loan is established at the time of application. Well known indexes include the Constant Maturity Treasury (CMT), Treasury Bill (T-Bill), 12-Month Treasury Average (MTA), 11th District Cost of Funds Index (COFI), Cost of Savings Index (COSI), London Inter Bank Offering Rates (LIBOR), Certificates of Deposit (CD) Indexes, and Prime Rate. The new interest rate is determined by adding the index and the margin. The margin is fixed percentage points added to the index to compute the interest rate. The result will then be rounded to the nearest one-eighth of a percent. For example: If the index is 5.3% and the margin is 2.5%, then the new interest rate = 5.3% + 2.5% = 7.8%. The nearest to 0.8% is 0.75% = 6/8%. The result will be 7.75%. The margins remain fixed for the term of the loan and are not impacted by the financial markets and movement of interest rates. Lenders use a variety of margins depending upon the loan program and adjustment periods. Most ARMs have interest rate caps to protect borrowers from enormous increases in monthly payments. A lifetime cap limits the interest rate increase over the life of the loan. A periodic or adjustment cap limits how much the interest rate can rise at one time. With most ARMs, the interest rate can adjust every six months, once a year, or every 3, 5, 7, or 10 years. A loan with an adjustment period of 6 months is called a 6-month ARM; a loan with an adjustment period of 1 year is called a 1-year ARM, and so on. Most ARMs offer an initial lower interest rate than the fully indexed rate (index plus margin) during the initial period of the loan, which could be one month or a year or more. This is known as a teaser rate. All ARMs are available with 30-year terms and some with 15-year terms, and adjustable rate mortgages generally have a lower initial interest rate than fixed rate loans.
Negatively Amortizing Loans: Some types of ARMs offer payment caps rather than interest rate caps, which limit the amount the monthly payment can increase. If a loan has a payment cap but has no periodic interest rate cap, then the loan may become negatively amortized: if interest rates rise to the point that the monthly mortgage payment does not cover the interest due, any unpaid interest will get added to the loan balance, so the loan balance increases. However, the borrower always has the option to pay the minimum monthly payment, or the fully amortized amount due. For example, if a loan has a payment cap of 7.5% with a payment of $1,000 per month and interest rates rise, the new payment could go up to, say, $1,200 per month. But the capped payment is only $1075. The other $125 would get added to the loan balance to be paid off over time, unless the borrower decides to pay that amount now. The interest rate on negatively amortized loans can adjust monthly. The advantages of negatively amortized loans, also known as deferred interest loans, are that they allow borrowers to control cash flow (because the payment is relatively stable), take advantage of low interest rates relative to the market at any given time, and pay back the money borrowed today at a depreciated value years from now (because of natural inflation). Combined (Hybrid) Loans Hybrid loans, a combination of fixed and ARM loans, come in different varieties:
Fixed-period ARMs: With fixed-period ARMs homeowners can enjoy from three to ten years of fixed payments before the initial interest rate changes. At the end of the fixed period, the interest rate will adjust annually. Fixed-period ARMs—30/3/1, 30/5/1, 30/7/1 and 30/10/1—are generally tied to the one-year Treasury securities index. ARMs with an initial fixed period, in addition to lifetime and adjustment caps, usually also have a first adjustment cap. It limits the interest rate paid the first time the rate is adjusted. First adjustment caps vary with the type of loan program. The advantage of these loans is that the interest rate is lower than for a 30-year fixed (the lender is not locked in for as long, so their risk is lower and they can charge less) but there is still the benefit of a fixed rate for a period of time. Two-Step Mortgage Two-step mortgages have a fixed rate for a certain time, most often 5 or 7 years, and then the interest rate changes to a current market rate.
Two-step mortgages can be convertible or nonconvertible. With a convertible two-step mortgage, also known as a 5/25 or a 7/23, the interest rate for the initial five or seven years is fixed. The loan then converts to a fixed-rate mortgage (at a different interest rate) for the remaining 25 or 23 years, respectively. A non-convertible two-step mortgage means that the 5/25 or 7/23 has a fixed interest rate for the first five or seven years, then converts into an ARM that adjusts annually for the remaining 25 or 23 years of the loan.
Convertible ARMs: Some ARMs come with an option to convert them to a fixed-rate mortgage at designated times (usually during the first five years on the adjustment date), if interest rates start to rise. The new rate is established at the current market rate for fixed-rate mortgages. The conversion is typically done for a nominal fee and requires almost no paperwork. The disadvantage is that the conversion interest rate is typically a little higher than the market rate at that time. The other kind of convertible mortgage is a fixed rate loan with a rate reduction option. If rates have dropped since the time of closing, this type of mortgage allows the borrower, under some prescribed conditions and for a small conversion fee, to adjust the mortgage to the going market rate.
Graduated Payment Mortgages: (GPMs) Graduated payment mortgages have payments that start low and gradually increase at predetermined times. A lower initial payment allows a borrower to qualify for a larger loan amount. The monthly payments will eventually be higher in order to catch up from the lower payments. In fact, the loan will be negatively amortizing during the early years of the loan, then the principal will be paid off at an accelerated pace through the later years. Lenders offer different GPM payment plans, which vary in the rate of payment increases and the number of years over which the payments will increase. The greater the rate of increase or the longer the period of increase, the lower the mortgage payments in the early years.
Buydown Mortgage: A temporary buydown is the type of loan with an initially discounted interest rate which gradually increases to an agreed-upon fixed rate usually within one to three years. An initially discounted rate allows you to qualify for more house with the same income and gives you the advantage of lower initial monthly payments for the first years of the loan when extra money may be needed for furnishings or home improvements. To reduce your monthly payments during the first few years of a mortgage you make an initial lump sum payment to the lender. If you do not have the cash to pay for the buydown, the lender can pay this fee if you agree on a little higher interest rate. A very popular buydown is the 2-1 buydown. 3-2-1 and 1-0 buydowns are also available, though less common. The compressed buydown works the same way, but with the interest rate changing every six months instead of yearly. The lower rate may apply for the full duration of the loan or for just the first few years. A buydown results in lower payments and may be used to qualify a borrower who would otherwise not qualify . With a variety of different loan programs available, it is important to choose the type of loan that will best suit your needs. Author: Jim Renshaw
Fixed Rate Mortgages With fixed rate mortgage (FRM) loans, the interest rate and monthly payments remain fixed for the period of the loan. Fixed-rate mortgages are available for 40, 30, 25, 20, 15, and 10 years. Generally, the shorter the term of a loan, the lower the interest rate. The most popular mortgage terms are 30 and 15 years. With the traditional 30-year fixed rate mortgage, monthly payments are lower than they would be on a shorter term loan. But if a borrower can afford higher monthly payments, a 15-year fixed-rate mortgage allows repayment twice as fast and saves more than half the total interest costs of a 30-year loan. The payments on fixed rate fully amortizing loans are calculated so that at the end of the term the mortgage loan is paid in full. During the early amortization period, a large percentage of the monthly payment is used for paying the interest. As the loan is paid down, more of the monthly payment is applied to principal. With bi-weekly mortgage plans, a borrower pays half of the monthly mortgage payment every two weeks. Because of the extra principal paid each year, the loan is repaid in less time. For example, a 30 year loan can be paid off within 21–23 years.
Adjustable Rate Mortgages A variable or adjustable rate loan is a loan whose interest rate, and therefore monthly payments, fluctuate over the period of the loan. With this type of mortgage, periodic adjustments based on changes in a defined index are made to the interest rate. The index for a particular loan is established at the time of application. Well known indexes include the Constant Maturity Treasury (CMT), Treasury Bill (T-Bill), 12-Month Treasury Average (MTA), 11th District Cost of Funds Index (COFI), Cost of Savings Index (COSI), London Inter Bank Offering Rates (LIBOR), Certificates of Deposit (CD) Indexes, and Prime Rate. The new interest rate is determined by adding the index and the margin. The margin is fixed percentage points added to the index to compute the interest rate. The result will then be rounded to the nearest one-eighth of a percent. For example: If the index is 5.3% and the margin is 2.5%, then the new interest rate = 5.3% + 2.5% = 7.8%. The nearest to 0.8% is 0.75% = 6/8%. The result will be 7.75%. The margins remain fixed for the term of the loan and are not impacted by the financial markets and movement of interest rates. Lenders use a variety of margins depending upon the loan program and adjustment periods. Most ARMs have interest rate caps to protect borrowers from enormous increases in monthly payments. A lifetime cap limits the interest rate increase over the life of the loan. A periodic or adjustment cap limits how much the interest rate can rise at one time. With most ARMs, the interest rate can adjust every six months, once a year, or every 3, 5, 7, or 10 years. A loan with an adjustment period of 6 months is called a 6-month ARM; a loan with an adjustment period of 1 year is called a 1-year ARM, and so on. Most ARMs offer an initial lower interest rate than the fully indexed rate (index plus margin) during the initial period of the loan, which could be one month or a year or more. This is known as a teaser rate. All ARMs are available with 30-year terms and some with 15-year terms, and adjustable rate mortgages generally have a lower initial interest rate than fixed rate loans.
Negatively Amortizing Loans: Some types of ARMs offer payment caps rather than interest rate caps, which limit the amount the monthly payment can increase. If a loan has a payment cap but has no periodic interest rate cap, then the loan may become negatively amortized: if interest rates rise to the point that the monthly mortgage payment does not cover the interest due, any unpaid interest will get added to the loan balance, so the loan balance increases. However, the borrower always has the option to pay the minimum monthly payment, or the fully amortized amount due. For example, if a loan has a payment cap of 7.5% with a payment of $1,000 per month and interest rates rise, the new payment could go up to, say, $1,200 per month. But the capped payment is only $1075. The other $125 would get added to the loan balance to be paid off over time, unless the borrower decides to pay that amount now. The interest rate on negatively amortized loans can adjust monthly. The advantages of negatively amortized loans, also known as deferred interest loans, are that they allow borrowers to control cash flow (because the payment is relatively stable), take advantage of low interest rates relative to the market at any given time, and pay back the money borrowed today at a depreciated value years from now (because of natural inflation). Combined (Hybrid) Loans Hybrid loans, a combination of fixed and ARM loans, come in different varieties:
Fixed-period ARMs: With fixed-period ARMs homeowners can enjoy from three to ten years of fixed payments before the initial interest rate changes. At the end of the fixed period, the interest rate will adjust annually. Fixed-period ARMs—30/3/1, 30/5/1, 30/7/1 and 30/10/1—are generally tied to the one-year Treasury securities index. ARMs with an initial fixed period, in addition to lifetime and adjustment caps, usually also have a first adjustment cap. It limits the interest rate paid the first time the rate is adjusted. First adjustment caps vary with the type of loan program. The advantage of these loans is that the interest rate is lower than for a 30-year fixed (the lender is not locked in for as long, so their risk is lower and they can charge less) but there is still the benefit of a fixed rate for a period of time. Two-Step Mortgage Two-step mortgages have a fixed rate for a certain time, most often 5 or 7 years, and then the interest rate changes to a current market rate.
Two-step mortgages can be convertible or nonconvertible. With a convertible two-step mortgage, also known as a 5/25 or a 7/23, the interest rate for the initial five or seven years is fixed. The loan then converts to a fixed-rate mortgage (at a different interest rate) for the remaining 25 or 23 years, respectively. A non-convertible two-step mortgage means that the 5/25 or 7/23 has a fixed interest rate for the first five or seven years, then converts into an ARM that adjusts annually for the remaining 25 or 23 years of the loan.
Convertible ARMs: Some ARMs come with an option to convert them to a fixed-rate mortgage at designated times (usually during the first five years on the adjustment date), if interest rates start to rise. The new rate is established at the current market rate for fixed-rate mortgages. The conversion is typically done for a nominal fee and requires almost no paperwork. The disadvantage is that the conversion interest rate is typically a little higher than the market rate at that time. The other kind of convertible mortgage is a fixed rate loan with a rate reduction option. If rates have dropped since the time of closing, this type of mortgage allows the borrower, under some prescribed conditions and for a small conversion fee, to adjust the mortgage to the going market rate.
Graduated Payment Mortgages: (GPMs) Graduated payment mortgages have payments that start low and gradually increase at predetermined times. A lower initial payment allows a borrower to qualify for a larger loan amount. The monthly payments will eventually be higher in order to catch up from the lower payments. In fact, the loan will be negatively amortizing during the early years of the loan, then the principal will be paid off at an accelerated pace through the later years. Lenders offer different GPM payment plans, which vary in the rate of payment increases and the number of years over which the payments will increase. The greater the rate of increase or the longer the period of increase, the lower the mortgage payments in the early years.
Buydown Mortgage: A temporary buydown is the type of loan with an initially discounted interest rate which gradually increases to an agreed-upon fixed rate usually within one to three years. An initially discounted rate allows you to qualify for more house with the same income and gives you the advantage of lower initial monthly payments for the first years of the loan when extra money may be needed for furnishings or home improvements. To reduce your monthly payments during the first few years of a mortgage you make an initial lump sum payment to the lender. If you do not have the cash to pay for the buydown, the lender can pay this fee if you agree on a little higher interest rate. A very popular buydown is the 2-1 buydown. 3-2-1 and 1-0 buydowns are also available, though less common. The compressed buydown works the same way, but with the interest rate changing every six months instead of yearly. The lower rate may apply for the full duration of the loan or for just the first few years. A buydown results in lower payments and may be used to qualify a borrower who would otherwise not qualify . With a variety of different loan programs available, it is important to choose the type of loan that will best suit your needs. Author: Jim Renshaw
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