Conventional Loans
Fixed-Rate Mortgages
Advantages of a fixed-rate mortgage - Predictable, stable monthly payments
A fixed-rate mortgage offers a straightforward monthly payment. With a fixed-rate mortgage, your interest rate—and your total monthly payment of principal and interest—will stay the same for the entire term of the loan. That predictability makes it easier to set your budget and there will not be any surprises in the future.
Fixed-rate mortgages are a good choice if you:
- Think interest rates could rise in the next few years and want to keep the current rate
- Intend to stay in your house for many years
- Prefer the stability of a fixed principal/interest payment to a payment that changes periodically
è --> Fixed rate Term Options
Fixed rate mortgages are available for 30 yrs, 25 yrs, 20 yrs, 15 yrs, and a few lenders even offer as short as a 10 yr term or as long as a 40 yr term. Generally, the shorter the term, the lower the rate.
With a 30-year fixed-rate loan, you would have a lower monthly mortgage payment compared with a 15-year fixed-rate mortgage, but you’ll pay more interest over the term of the 30-year loan. Depending on what you can comfortably afford for a monthly mortgage payment, a 30-year fixed-rate loan might be a better fit for your budget.
Adjustable Rate Mortgages
Advantages of an Adjustable Rate Mortgage (ARM)
è Lower initial interest
Adjustable-rate mortgage (ARM) loans provide a low interest rate for an initial payment period, then your rate and/or payment will adjust periodically based on the terms of the ARM product.
Adjustable-rate mortgages are a good choice if you:
- Are planning to move in a few years (before the end of the initial rate period) and therefore aren't concerned about possible rate and/or payment increases
- Expect your income to rise enough in the coming years to cover any increase in payments resulting from an increase in the interest rate
- Want a lower initial monthly payments than a fixed-rate mortgage usually offers
- Think interest rates may fall in the future – if rates drop when your rate adjusts, your rate and payments may also drop if this happens
Interest Only Mortgages
Some lenders offer interest only options on the ARM loans that are offered. An interest-only mortgage or loan enables borrowers to put off or defer payments of principal and pay only monthly interest on a mortgage for a given period of time. This type of loan usually offers one, three, five or 10-year interest only periods.
After that time has been reached, the borrowers are required to pay down (amortize) their mortgage at an accelerated rate. If you are considering this type of loan, it is important to realize that once the ‘interest only” period has passed, there is a very good chance that your loan payment will be much higher. It is also important to recognize that this type of loan program was a large contributor to the current housing situation since many homeowners could not afford to pay their much larger mortgage payments after their interest only period passed.
Disadvantages of an Adjustable Rate Mortgage (ARM)
Some disadvantages of adjustable-rate mortgages:
- Interest rates will increase in a rising rate environment
- Increase in rates will increase payment amount, which may not keep pace with your income level
- Increase in interest rate will reduce accumulation of equity, especially where home values are declining, and may make it more difficult to refinance your loan
Adjustable Rate Term Options
Adjustable Rate Mortgages are available as 3/1 ARMS, 5/1 ARMs, 7/1 ARMS, and 10/1 ARMs A few lenders even offer as short as a 1yr ARM and the rate trend is similar to fixed rates. The shorter the fixed term (3,5,7,or 10), the lower the rate. Here are conditions pertaining to an ARM loan using the 5/1 ARM as an example:
A 5/1 ARM has a fixed interest rate for the first 5 years. After 5 years, the rate can change once every year for the remaining life of the loan. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.
How Adjustable Rate Loans Work:
ARM loans are available for a 30 year† term, and in some cases as long as a 40 yr term (although this is becoming more rare with lenders now). In addition to the term, ARMs have different options for how long the initial interest rate will last before the rate can start to adjust. So, for example, you could get a 5/1 ARM, and your interest rate and payment would stay the same for 5 years before being open to annual adjustment.
After the lower initial rate period, the ARM loan's interest rate will adjust to a fully indexed rate, and at that time, your rate and your payments may increase. If the rate goes up after the initial period, your monthly payments go up, so you want to be financially prepared to make larger payments. The “1” shown in the listed adjustable loan products represent how often the loan can adjust. This means 1 yr, so the loan can adjust annually, but are subject to adjustment caps. There is an adjustment cap for the 1st adjustment, and also an adjustment cap for the life of the loan.
When you consider ARM loans, find out how and when your rate can change, because those factors will determine how much your monthly payment is. It is important to really understand these products if you are considering it because these loans are not for everyone and many homeowners have lost their homes due to unexpected increases to their payments which they could not afford. It is not always possible to refinance out of an ARM product into a fixed rate one unless you can qualify for the new loan with income, credit and sufficient equity.
ARM Interest Rate Caps and Indexes
On all ARM products, the rate you pay on an ARM after the initial rate is based on a fluctuating index plus a fixed extra amount, called a margin. As an example, if the interest rate for the financial index was 4.0% and your margin was 2.5%, then your rate at the time of adjustment would be 6.5%. Keep in mind that different indexes go up and down faster than others, and both the index used and the margin can vary among lenders. How often your payments are adjusted based on the index, and how much rates and payments increase at each adjustment, depends on your loan terms.
ARM interest rate caps
ARM loans typically feature an adjustment "cap" which limits how much the interest rate can go up. The maximum payment should be factored into your budget. Rate caps can limit the size of interest rate changes both for periodic adjustments and for the life of the loan.
ARM financial indices
Every ARM loan uses a money rate index to determine the loan rate for a set period. Lenders have no control over any of these rate indices. You can track the performance of each index in The Wall Street Journal. These indices are used as benchmarks when re-setting the loan at each adjustment period and is added to your margin (which remains the same from period to period) to generate the new rate. Some common ARMs and the indices on which they're based are shown here:
There are some rate indices that may adjust more frequently than every year, but the most common ARM products are based on a once a year adjustment.
a) Treasury-Indexed ARMs (T-Bills)
Tracks the weekly average yield of U.S. Treasury securities adjusted to a constant maturity of 6 months or 1 year.
b) London Interbank Offered Rate ARMs (LIBOR)
The LIBOR index tracks the rate international banks charge each other for large loans in the London interbank market. This ARM adjusts to the LIBOR annually based on the 1-year U.S. dollar–denominated deposits in the London market, as published in The Wall Street Journal. The 1-year LIBOR ARM has a lifetime cap of 5%.
c) Prime Rate
Prime rate, which is the rate at which banks will lend money to their most-favored customers. The prime rate will move up or down with changes made by the Federal Reserve Board.This index is usually linked to rates charged on Home Equity Lines of Credit
d) 11th District Cost of Funds
A monthly cost-of-funds index (COFI) reflecting the weighted-average interest rate paid by 11th Federal Home Loan Bank District savings institutions for savings and checking accounts. The 11th district covers Arizona, California and Nevada. The index is published on the last day of the month and reflects the cost of funds for the prior month.
COFI usually lags market interest rates in both up and down markets. That means loans tied to this index rise and fall more slowly than rates in general.