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You are probably familiar with a
fixed rate mortgage. Your parents more than likely had one, as
did their parents before them. The major advantage of fixed rate
mortgages is that they present predictable housing costs for the
life of the loan. Some fixed rate mortgages you will probably
hear about are:
- 30-year fixed rate
mortgages
- 15-year fixed rate
mortgages
- biweekly mortgages
- "Convertible"
mortgages
When people thought of a mortgage
10 to 50 years ago, they thought of a 30-year fixed rate
mortgage. This traditional favorite is not the only choice
nowadays because volatile financial times created a whole new
range of selections. However, the 30-year fixed rate mortgage may
still be the best mortgage for your circumstances. It offers the
lowest monthly payments of fixed rate loans, while providing for
a never- changing monthly payment schedule. Some lenders offers
25,20, and even 40-year term mortgages as well. But remember, the
longer the term of the loan, the more total interest you will
pay.
The 15-year fixed rate mortgage
allows homeowners to own their homes free and clear in half the
time and for less than half the total interest costs of the
traditional 30-year loan. The loan's term is shortened by the
10 percent to 15 percent higher monthly payments. Some home
buyers prefer this mortgage because it allows them to own their
home before their children start college. Others prefer it
because they will own their home free and clear before retirement
and probable declines in income.
The major disadvantages or the
15-year fixed rate mortgage are the sometimes higher monthly
payments. But if saving on total interest costs and cutting the
to free and clear ownership are important to you, the 15-year
fixed rate mortgage is a good option. The biweekly mortgage
shortens the loan term to 18 to 19 years by requiring a payment
for half the monthly amount every two weeks. The biweekly
payments increase the annual amount paid by about 8 percent and
in effect pay 13 monthly payments(26 biweekly payments) per year.
The shortened loan term decreases the total interest costs
substantially. The interest costs for the biweekly mortgage are
decreased even farther, however, by the application of each
payment to the principal upon which the interest is calculated
every 14 days. By nibbling away at the principal faster, the
homeowner saves additional interest. Remember, however, that you
trade lower total interest costs for fewer mortgage interest
deductions on your federal income tax. Your ability to qualify
for this type of loan is based on a 30-year term, and most
lenders who offer this mortgage will allow the home buyer to
convert to a more traditional 30-year loan without penalty.
Availability is limited on this mortgage, but it can be worth
looking for.
Some newer mortgages afford home
buyers some the best qualities of the fixed rate and adjustable
rate mortgages. One new type of loan, often called a Two-Step,
Super Seven, or Premier Mortgage, gives homeowners the
predictability of a fixed- rate and adjustable rate mortgage for
a certain time, most often seven or 10 years, and then the
interest rate is adjusted to fit market conditions at that time.
The main advantage associated with this type of loan is that home
buyers often get a slightly lower than market rate to begin with.
The main disadvantage is that they may see their interest rate go
up by as much as six percentage points at the end of the
seven-year period. The lender may also reserve the option to call
the loan due with 30 days notice at that time, making this loan
similar to a balloon mortgage in some cases.
Lenders offer this type of loan in
part because research indicates that many home buyers remain in
the home for seven to 10 years before moving. For this type of
home buyer, the Two-Step or Super Seven loan present an excellent
way of getting a fixed rate loan at a better than market price
for a fixed period of time.
Another type of mortgage that is
becoming popular is called a Lender Buy down, where the home
buyer gets an initially discounted rate and gradually increases
to an agreed-upon fixed rate over a matter of three years. For
example: When the market rate is 10 percent, the fixed rate for
the mortgage is set at about 10.5 percent, but the home buyer
makes monthly payments based on a first year rate of 8.5 percent.
The second year the rate goes up to 9.5 percent, and for the
third year through the remaining life of the loan, the rate is
calculated at 10.5 percent. A second type of lender buy-down,
called a Compressed Buy down, works the same way, but with the
interest rate changing every six months instead of on a yearly
basis.
The Lender Buy down gives
consumers the advantage of lower initial monthly payments for the
first two years of the loan when extra money may be needed for
furnishings and, secondly, the advantage of knowing that,
although the interest rate does change during the first three
years of the loan, the interest is fixed from the third year
on.
Convertible mortgages offer
today's home buyer the option to change the loan's
interest rate after some period of time or some specified
movement in interest rates.
Convertible fixed rate mortgages
are often referred to as the Reduction Option Loan (ROL) or, in
some locations, the Reducing Interest Loan (RIL), or Mortgage
(RIM). This new type of loan offers homeowners the option of
getting a loan that , under the right conditions, can be adjusted
to a lower interest rate with a payment of $100 or $200 or so and
a small loan amount-based fee, sometimes as little as one-fourth
of a percentage point. These conditions usually are a prescribed
movement in rates-typically two percent below the initial- during
a set time limit-between months 13 and 59, for
example.
On a 30-year fixed rate mortgage
with a reduction option, the home buyer pays an extra one-fourth
to three-eighths of a percentage point in the interest rate on
the mortgage plus a quarter to three-eighths of 1 percent of the
loan amount (points) at the time of closing. This allows the
homeowners to adjust the interest rate on the loan without having
to go through a refinancing, which could cost up to 5 percent or
6 percent of the loan amount, if the rates are right during the
prescribed time limit.
On an $80,000 loan, this means
that you could reduce the interest rate on your loan from, say,
10.5 percent to 8.5 percent, and take advantage of the low rates
for the rest of the loan term for $150 instead of up to $4,800 ,
if the rates dropped to that point during your "window of
opportunity" - months 13 through 59. Some homeowners may
find the ROL a good "insurance policy" against the high
costs of refinancing. Others may want the flexibility that
refinancing offers - namely the ability to draw on built-up
equity- that is not available with ROLs. The decision is up to
you.
Convertible Adjustable Rate
Mortgages (ARM's) are another new loan product on today's
market. It worked like any other ARM, but it offers homeowners a
distinct advantage-it allows them to turn their ARM into a fixed
rate mortgage after a set period (usually during the second
through fifth years of the loan).
A new product developed by the
Federal National Mortgage Association (Fannie Mae), which buys mortgages
from lenders, allows the homeowner to convert an ARM to either a
15 or 30 year fixed rate mortgage for a fee of 1 percent of the
original loan plus $250 , as compared to the 3 percent to 6
percent costs of refinancing. Say, for instance, that you got
your convertible ARM at an initial interest rate of 10.0 percent,
and after a year or so, rates had dropped to 8.0 percent. For the
smaller conversion fee, you could adjust your mortgage to either
a 15 or 30 year fixed rate loan at a new rate that would be about
one-half percent higher than the going market rate, or 8.5
percent. There are other variations on this loan available from
lenders across the country. Home buyers who want the low initial
rate of an ARM, and the option and peace of mind of a fixed
mortgage should rates drop, can now have it both ways.
Adjustable Rate Mortgages
(ARM's) have become on of the most popular and effective
tools for helping some prospective home buyers achieve their
dream of home ownership. Developed during a time of high interest
rates that kept many people out of the housing market, the ARM
offers lower initial rates by sharing the future risk of higher
rates between borrower and lender.
ARM's can be an excellent
choice of financing under certain conditions, such as rising
income expectations, high interest rates, and short-term home
ownership. But because payments and interest rates can increase,
either steadily or irregularly, home buyers considering this kind
of mortgage need to have the income to keep up with all possible
rate and/or payment changes. Each ARM has four basic
components:
- Initial interest rate,
which is typically one to three percentage points lower than that
of most fixed rate mortgages. Lower interest rates also make
ARM's somewhat easier to qualify for. The initial interest
rate is tied to certain economic indicators that dictate in part
what the monthly payments will be.
- Adjustment interval, at
the time between changes in the interest rate and/or monthly
payment will be.
- Index, against which
lenders measure the difference between what they are making on
their investment in the mortgage and what they could be making on
other types of investments. The most popular index is based on
the rate of return on a one- year Treasury bill (also called
T-bill).
- Margin, or the additional
amount the lender adds to the index to establish the adjusted
interest rate on an ARM. The margin is usually 1.5 percent to 2.5
percent.
In addition to the four basic
components, an ARM usually contains certain consumer safeguards
such as interest rate caps, which limit the amount that the
interest rate applied to the payments may move. This prevents the
amount of interest the consumer pays from rising higher than
perhaps the homeowner can afford. For instance, a typical ARM
would have a two percentage point cap over the life of the loan.
That means that a loan with an initial interest rate of 9.75
percent would be able to go no higher than 14.75 percent over the
life of the loan, and it would be able to move no more than two
percentage points per year.
Another safeguard found on some
ARM's are monthly payment caps that limit the amount
homeowners need to increase their payments at adjustment time.
Monthly payment caps can, however, sometimes prevent the monthly
payments from increasing enough to keep up with the rise in the
interest rate, causing negative amortization-resulting in higher
or more payments for the homeowner later on.
Other options you should ask about
when shopping for an ARM are:
- Assumability, or whether you may
transfer the mortgage to a new home buyer, usually with the same
terms if the new home buyer qualifies for the loan. ARM's are
almost always assumable.
- Convertibility allows the
borrower to change an ARM to a fixed rate mortgage, usually at
the end of some predetermined period, locking in a lower interest
rate.
A relative newcomer in the
mortgage market is a Reverse Annuity Mortgage (RAM). For older
Americans, especially retirees living on fixed incomes, the
equity in their paid-for or almost-paid-for home represents a
large but liquid asset. The RAM is designed to help supplement
those homeowners' income.
The lender who will issue a RAM
appraises the property and makes the loan based on a percentage
of its current value. The homeowner retains ownership, and the
property secures the loan. The lender then pays an annuity to the
borrower, usually on a monthly basis, up to an amount equal to
the equity they have in the home.
The advantage of such a loan for
older Americans is that of receiving a monthly tax-free income.
Under one plan, this income is available for life or until the
house is sold at the homeowner moves. The schedule of payments
depends on the value of the home and the ages of the owners.
There are risks involved, however. If the homeowner wants to move
and buy a new house, there may not be enough equity in the home
to permit such a plan. Or the lender may consider only the
current market value of the home rather than any future
appreciation when deciding on the monthly payments.
The Federal Housing Administration
(FHA) and the Veterans Administration (VA) offer a wide range of
mortgage choices that may appeal to you. These include 30 and 15
year fixed- rate mortgages, as well as ARM's. Insured by
these government agencies, the loans feature low or no down
payment terms and are often assumable by future purchasers. VA
loans are restricted to individuals qualified by military service
or other entitlements, but FHA - insured loans are open to all
qualified home purchasers. Note that there are limits to handle
moderate-priced homes anywhere in the country. Talk to your
lender about FHA/VA possibilities.
This type of financing became
popular when interest rates went to very high levels in the early
1980s. Seller-assisted creative financing usually means the
seller of the home helps with the financing by underwriting all
or part of the loan.
The advantage of this type of
arrangement is that the mortgage usually carries a lower interest
rate with lower monthly payments. The disadvantage is that the
previous homeowner, not an institution, may hold the deed of
trust. If the loan terms call for certain payment schedules, the
buyer may have to seek new financing. Many home buyers in recent
years have found "creative financing" deals to be
fraught with problems and useful only as short-term alternatives
to mortgages from traditional lenders.
One type of mortgage you are apt
to run into with seller financing is the balloon payment
mortgage. Balloons, as they are known, are usually offered as
short-term fixed rate loans. The balloon payment mortgage gets
its name from the payment schedule, which involves smaller
payments for a certain period of time and one large payment for
the entire amount of the outstanding principal. They have terms
of 3, 5, and sometimes 15 years, though payments are usually
calculated as though it were a 30 year loan. Sometimes a balloon
will be offered as a second mortgage where you also assume the
homeowner's first mortgage . The major disadvantage with a
balloon payment loan is that it may be difficult to save up the
money to make the final large payment (often the entire amount of
the principal) while paying interest on the loan. Some lenders
guarantee refinancing, though the interest rate is usually
adjusted when the principal comes due. If you cannot refinance,
you may have to the property if you cannot meet the large
payment. Balloons are an advantage if you plan on living in an
appreciating house for a short period of time and want to pay
less while you live there.
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