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Fixed Rate or Adjustable, Which is Right for You?
Here is the simplest definition of the different loan types. If you are someone who is more comfortable with always knowing what your payment will be over the term of the loan, than a Fixed Rate Loan may be what you need; however, if you need to qualify for as much of a loan as possible and the initial interest rate on an ARM makes that possible, than an Adjustable Rate Loan may be for you.
What your lender does is custom tailor your loan to meet your needs so that there are no surprises. The purchase or refinancing of your property with the best possible loan and rate is our only goal.
| Type: |
30 Year Fixed Rate Loan |
| Definition: |
The interest rate and
payment never change over the 30 year repayment period |
| Advantages: |
Payments never increase |
| Disadvantages: |
Slow equity buildup |
| Comments: |
The most common mortgage
in US, good choice when rates are low |
| Type: |
15 Year Fixed Rate Loan |
| Definition: |
The interest rate and
payment never change over the 15 year repayment period |
| Advantages: |
Usually lower interest rate
than 30 year fixed rate loan, less interest paid because
the loan is paid sooner, faster equity buildup because you
are making bigger payments. |
| Disadvantages: |
Higher monthly payments. |
| Comments: |
A good option for those who
can handle the higher payments and want shorter pay-off
time |
| Type: |
ARM = Adjustable Rate Mortgage
|
| Definition: |
The interest rate changes
over time |
| Advantages: |
Low interest rate in the
beginning sometimes below market rate |
| Disadvantages: |
Payments may rise and this
may be a hardship if rates increase significantly |
| Comments: |
Good option if you know
your income will rise and/or rates are expected to drop |
Fixed Rate Loans
A long-term fully amortized loan has distinct advantages for the borrower. The
equal payments are spread out over a long period of time keeping the payments
manageable and there is no balloon payment required at the end of the loan term.
This type of loan is the most popular with borrowers mostly because this is the
type of loan program that they are most familiar with.
Adjustable Rate Loans
There are many variations on an adjustable rate mortgage. When we talk
about a "six month ARM" we mean that the loan is for 30 years
with an interest rate and monthly payment that adjusts every six months.
A 7/1 ARM is a loan with a fixed interest rate and monthly payments
for the first seven years then an interest rate that is adjustable
annually for the remaining 23 years. The lender is protected because
the company can raise the interest rate as rates go up (after the seven
year fixed rate period) so they feel that they can offer lower interest
than they can on fixed rate loans. There is a "cap" or fixed
amount that the interest can increase each year over the term of the
loan. With this example (7/1), if you were going to stay in the house
for seven years or less, you would be able to take advantage of the
lower interest rate. If you were to stay longer than the seven years
and the interest rate went up, your payments would go up also.
How an ARM Works
The borrower's interest rate is determined by the cost of money at the
time the loan is made. Then the rate is tied to a recognized index
your lender is currently using for this loan. Your future interest
adjustments are then based on the upward or downward movements of this
index. An index is a reliable statistical report that reflects the
approximate change in the cost of money. Some examples of this would
be the monthly average yield on three year treasury securities, or
the national average mortgage contract rate for purchases on previously
occupied homes. The rise and fall of your payments will fluctuate with
the index preferred by the lender for this loan program when your loan
was made.
To insure that the expenses of administration and profit are included
in the payments to the lender, it is necessary for the lender to add
a margin to the index. Different lenders use different margins which
explains the variation in interest rates offered for the same loan program.
Margins range from 2% to 4% and are added to the index to come up with
the interest rate you pay (margin + index = interest rate). It's the
fluctuation of the index rate that causes the borrowers interest rate
to increase or decrease.
Index:
Lenders generally use an index that will be responsive to fluctuations
in our economy - usually a one-year Treasury security or the cost-of-funds
index (COFI). The cost-of-funds index is more stable than the Treasury
index because it doesn't rise or fall as sharply over the long term as
the Treasury index.
Margin:
The margin is the difference between the index rate and the interest
charged to the borrower. The margin doesn't change throughout the loan
term.
"Teaser Rates"
A "teaser rate" is a reduced, first-year introductory interest
rate designed to attract borrowers to ARM's. In the past, lenders were
losing money on fixed-rate mortgages because these loans were yielding
less than the prevailing cost of money. Offering the adjustable-rate
mortgage allowed lenders to insulate themselves from these losses and
increase earnings by passing the risk of interest rate fluctuations on
to the borrower. To make the ARM attractive to borrowers, a low beginning
interest rate was offered and through time these introductory rates became
known as "teaser rates". The interest rate would then rise
at each rate adjustment period until the rate equaled the index rate
+ the margin. For example, let's say that the introductory rate ("teaser
rate") for your adjustable-rate loan started at 4.5% interest and
would adjust upward 1.0% every six months. If your index for this loan
was 5.0% and the lenders margin was 3.0%, then the interest on your loan
for the first six months would be 4.5%. Six months later, it would increase
to 5.5% and so on until the fully-indexed rate was reached. To find the
fully-indexed rate, you would add the index to the margin (5.0% + 3.0%).
After the fully-indexed rate was reached, your loan would then fluctuate
with the index on your loan. If the index goes up or down, your payment
would increase or decrease with the rise or fall of the index on your
adjustment period change date.
Rate Adjustment Period:
The borrowers interest rates on an adjustable-rate mortgage are allowed
to be adjusted at certain intervals during the loan term. Depending
on the type of adjustable loan you have, this interval could be six
months, one year, three years or more.
Interest Rate Cap:
There are limits on just how much your payments can go up if you have
an ARM. Usually these caps are in the form of interest rate caps and/or
payment caps. An interest rate cap determines the maximum number of
percentage points your interest can increase over the life of the loan.
Mortgage Payment Adjustment Period:
The mortgage payment adjustment period is the agreed upon intervals at
which the payments of principal and interest are changed. The lender
can either adjust the rate periodically and adjust the mortgage payment
to reflect the change, or the lender can adjust the rate more frequently
than the mortgage payment is adjusted. For example, the loan agreement
may call for the interest to be adjusted every six months, but the
payment to be adjusted every three years. This scenario could be a
problem. If in the interim between payment periods (3 years), interest
rates have gone up or down too much, there will have been too much
or too little interest paid on the loan by the borrower over that period
of time, and the difference will be added to or subtracted from the
loan balance. When unpaid interest is added to the loan balance, it
is called negative amortization.
Mortgage Payment Cap:
A mortgage payment cap is the maximum allowable interest rate the lender
can charge on your loan regardless of what happens in the market. Depending
on your particular loan program, this is a percentage (usually 5% to
7.5% annually) that can be added to your fully indexed rate if the
market warrants moving that high. For example, if your fully indexed
rate is 8% and your annual cap is 6%, your loans life cap would be
14%.
Mortgage payment caps were designed to limit unrestricted increases
by lenders and keep the borrowers payments at a manageable level. Some
lenders impose payment caps, some impose interest rate caps and some
lenders use both.
Negative Amortization Cap:
A negative amortization cap limits the amount of negative amortization
that can be reached on a loan. When the cap is reached, the loan is
re-amortized to a level sufficient to pay off the loan over the remaining
term of the loan.
Conversion Option:
A conversion option on an adjustable rate mortgage is called a Convertible
ARM. A conversion option gives the borrower the option to convert their
adjustable-rate mortgage to a fixed-rate loan. Convertible Arm's normally
have a higher initial interest rate (even the converted fixed rate
will usually be higher). You will usually have a time frame in which
to convert the loan to a fixed rate. For example, you might have to
make your decision to convert the loan sometime after the first year
and before the fifth year ends. In most cases, there is also a conversion
fee imposed on the borrower (for instance 1% of the total loan amount).
Permanent Buydowns
Buyers can obtain rates that are lower than the going daily rate offered
by paying additional discount points. (Discount points are fees paid
to the lender to reduce the interest rate. When you "buy a loan
down" you are paying some "extra" money upfront and
getting a lower interest rate over the life of the loan.)
In a "buyers market" (when it is difficult to sell a house)
a seller may be willing to pay the discount points to obtain the loan
for the buyer. Talk to your Realtor® to determine if it is possible
to ask the seller to pay for this. Everything is negotiable when purchasing
property. Don’t be surprised; however, if the seller says "no".
The home market is very "hot" right now ("sellers’ market")
and some sellers are getting multiple offers so they don’t have
to make concessions or pay for buyer advantages like "buydowns" to
sell their home.
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