Understanding the mortgage options available to you is a key step in the home buying process. Below is a brief overview of the most common types of mortgages.
The major advantage of a fixed-rate mortgage is that it presents predictable housing costs as your interest rate, monthly principal and interest (P&I) payments remain the same for the life of the loan. They are:
% Term—Fixed Rate Mortgages are available from 10, 15, 20 or even 30 years.
Predictable Interest Rate—Your interest rate, monthly principal and interest (P&I) payments stay the same for the life of the loan.
Security—You’ll be protected against the possibility of rising interest rates or other market fluctuations.
Control—If you don’t expect your monthly income to rise significantly and/or you plan to stay in your home for a number of years, a fixed-rate mortgage can be the right choice.
Adjustable Rate Mortgages (ARMs)
An ARM is a mortgage in which the interest rate is fixed for a period at the beginning, called the initial rate period. After a pre-defined period of time – typically 1, 3, 5, 7 or 10 years, the rate may change.
ARMs can be the right choice for financing under certain conditions:
Rising income expectations
High interest rate environment
Plans to refinance soon
Since monthly principal and interest payments may increase when the interest rates adjust, it is important for home buyers considering an ARM to be prepared with income to keep up. There is, of course, the chance the interest rate could remain the same or even drop, which is a further reason why an ARM may be an attractive choice.
Each ARM has five basic components. They are:
Initial Interest Rate—The rate is usually one to three percentage points lower than that of most fixed-rate mortgages. Lower initial interest rates also make ARMs somewhat easier to qualify. The initial interest rate ties to certain economic indicators that dictate in part what the monthly payment will be.
Interest Rate Caps— Interest rate caps are put in place to protect the consumer. A periodic cap limits the interest rate increase/decrease from one adjustment period to the next. A lifetime cap will limit the interest rate increase/decrease over the life of the loan. Most adjustable rate mortgages will adjust 1-2% at each adjustment with a lifetime cap of 5-6%.
Adjustment Interval—The time between changes in the interest rate and/or monthly payment; typically one, three, or five years, depending on what index is used. ARMs are generally offered in 1, 3, 5, 7 or 10 year terms.
Index—The benchmark that an ARMs full interest rate is based upon. The most common indexes are the one year Treasury and the five year Treasury.
Margin—The additional interest the lender adds to the index to establish the adjusted interest rate on an ARM.
A lender who offers ARMs must give a disclosure about its ARM program at the time the applicant is given an application form (or collects a non-refundable fee). A lender must notify you at least 45 days prior to a rate change.
Bank In-House Portfolio Programs
Bank in-house programs may allow greater flexibility in the approval process. Inquire with your bank.
Choosing Your Mortgage
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