YOUR RETIREMENT CENTER
Mortgage Rates

Mortgages can have either fixed or adjustable rates, or sometimes a hybrid of the two.
Fixed Rate You can often choose the method that's used to figure interest on your mortgage. With a fixed-rate loan, the total interest you'll owe is determined at closing. With an adjustable loan, the rate you pay changes as the cost of borrowing changes.

FIXED-RATE MORTGAGES Fixed-rate or conventional mortgages have been around since the 1930s. The total interest and monthly payments are set at the time the sale is finalized. You repay the principal and interest in equal, usually monthly, installments over a 15-, 20- or 30-year period. You know right from the start what you'll pay and for how long.

In most cases, though, you can choose to prepay your mortgage before the term is up, which means you'll owe less interest. Or you can renegotiate the loan to get a lower rate. However, with some loans, you may owe a prepayment penalty. That charge will be explained in your loan agreement.
 
PLUSES
  • You always know your housing costs, so you can plan your budget more easily
  • Your mortgage won't increase if interest rates go up
MINUSES
  • Initial rates and closing costs are usually higher than for ARMs
  • Your monthly payments may be larger than with ARMs
  • You won't benefit if interest rates drop, and you'll have to refinance
    if you want a lower rate

ADJUSTABLE-RATE MORTGAGES Adjustable-rate mortgages (ARMs) were introduced in the 1980s to help more buyers qualify for mortgages, and to protect lenders by letting them pass along higher interest costs to borrowers if rates went up during the term of the loan.

Adjustable Rate HOW ARMs WORK An ARM has a variable interest rate: The rate changes on a regular schedule — such as once a year — to reflect fluctuations in the cost of borrowing. Unlike fixed-rate mortgages, the total cost of borrowing can't be figured in advance, and monthly payments may rise or fall over the term of the loan.

Lenders determine the new rate using two measures:

  • An index, which is often a published figure, like the rate on the Constant Maturity Treasury (CMT) Indexes or the Cost-of-Funds Index (COFI) of the 11th Federal Home Loan Bank District. Be sure to find out which index your lender uses, since some fluctuate more — and change more rapidly — than others.
  • A margin, which is the number of basis points or hundredths of a percentage point, added to the index to determine the new rate.
 
PLUSES
  • Low initial rates (sometimes called teaser rates) reduce your closing costs and early monthly payments
  • Your interest rate may drop if interest rates go down
MINUSES
  • It's hard to budget housing costs, since monthly payments can change yearly
  • Interest costs may jump after the teaser rate expires
  • You may have to pay more interest if rates go up
 
CAPPED COSTSAll ARMs have caps, or limits, on the amount the interest rate can change. An annual cap limits the rate change each year (usually by two percentage points), while a lifetime cap limits the change over the life of the loan (typically to five or six percentage points).
HYBRID MORTGAGES
Choosing between a fixed-rate or an adjustable-rate mortgage isn't an all-or-nothing proposition. In fact, there are some hybrids that offer certain advantages of each type while softening some of their drawbacks.

Among the most popular are mortgages that offer an initial fixed rate for a specific period, usually five, seven, or ten years, and then are adjusted. The adjustment may be a one-time change, to whatever the current rate is. More typically, the rate changes regularly over the balance of the remaining loan term, usually once a year.

One appeal of the multiyear mortgage, as these hybrids are often called, is that the borrower can get a lower rate on the fixed-term portion of the mortgage than if the rate were set for the entire 30 years. That's because the lender isn't limited by a long-term agreement to a rate that may turn out to be unprofitable.

The lower rate also means it's easier to qualify for a mortgage, since the monthly payment will be lower. That's a real plus, especially if you're a first-time buyer.

For people who plan to move within a few years, especially if it's within the period during which they're paying the fixed rate, there's the added appeal of paying less now and not having to worry about what might happen when the adjustable period begins. In fact, the typical mortgage lasts only about seven years. Then the borrower moves or refinances and pays off the balance.
Be careful: Lifetime caps are often based on the actual index plus margin and not on the introductory rate. For example, despite a 3.5% teaser rate, with a 6% actual interest index plus a 50 point basis margin, your rate could go as high as 12% with a six-point lifetime cap.

NEGATIVE AMORTIZATION Negative amortization means you may owe extra interest when the mortgage ends, because interest rates have moved higher than your cap allowed the lender to charge you.

Not all ARMs allow negative amortization. If they do, typically the most that can accumulate is 125% of the original loan amount. Then some resolution must be arranged, such as a lump sum payment or loan extension.


TEASER RATES The introductory rate you pay for the first months of an adjustable-rate mortgage is almost always lower than the actual cost of borrowing the money. What it means for the borrower is not only a few months of relief but also lower closing costs. The effect is to make mortgages more accessible to more people.

What it means for the lender is being able to adjust the rate upward within a few months while staying competitive with other lenders.

 

 

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