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Mortgages can have either fixed or adjustable rates, or
sometimes a hybrid of the two.
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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.
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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
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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
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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.
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.
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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).
Be careful: Lifetime caps are often based on the actual index plus
margin and not on the introductory rate. For example, despite a 2.5% teaser rate,
with a 4% actual index plus margin, your rate could go as high as 10% 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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