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The interest rate on a mortgage is one of the most important factors in a homeowner’s monthly payments. The higher the rate, the more you will pay and the lower the interest rate, the lower your monthly payments and the higher your monthly savings.
A fixed-rate mortgage (FRM), often referred to as a “vanilla wafer” mortgage loan, is a fully amortizing mortgage loan where the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or “float”. As a result, payment amounts and the duration of the loan are fixed and the person who is responsible for paying back the loan benefits from a consistent, single payment and the ability to plan a budget based on the fixed cost
An adjustable-rate mortgage (ARM) refers to a mortgage regulated by the Federal government, with caps on charges. Adjustable-rate mortgage (variable-rate or tracker mortgage) is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets.
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Know Your Fixed Rate Mortgages
Fixed Rate Mortgages (FRM)
A fixed rate mortgage is a mortgage in which the interest rate and term remains the same throughout the life of the loan
Other forms of mortgage loans include interest only mortgage, graduated payment mortgage, variable rate (including adjustable rate mortgages and tracker mortgages), negative amortization mortgage, and balloon payment mortgage. Unlike many other loan types, FRM interest payments and loan duration is fixed from beginning to end. Fixed-rate mortgages are characterized by amount of loan, interest rate, compounding frequency, and duration. With these values, the monthly repayments can be calculated.
Unlike adjustable rate mortgages (ARM), fixed-rate mortgages are not tied to an index. Instead, the interest rate is set (or “fixed”) in advance to an advertised rate, usually in increments of 1/4 or 1/8 percent. The fixed monthly payment for a fixed-rate mortgage is the amount paid by the borrower every month that ensures that the loan is paid off in full with interest at the end of its term.
The United States Federal Housing Administration (FHA) helped develop and standardize the fixed rate mortgage as an alternative to the balloon payment mortgage by insuring them and by doing so helped the mortgage design garner usage. Because of the large payment at the end of the loan, refinancing risk resulted in widespread foreclosures. It was the first mortgage loan that was fully amortized (fully paid at the end of the loan) precluding successive loans, and had fixed interest rates and payments.
Fixed-rate mortgages are the most classic form of loan for home and product purchasing in the United States. The most common terms are 15-year and 30-year mortgages, but shorter terms are available, and 40-year and 50-year mortgages are now available (common in areas with high priced housing, where even a 30-year term leaves the mortgage amount out of reach of the average family).
Fixed rate mortgages are usually more expensive than adjustable rate mortgages. Due to the inherent interest rate risk, long-term fixed rate loans will tend to be at a higher interest rate than short-term loans. The relationship between interest rates for short and long-term loans is represented by the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and occurs less often.
The fact that a fixed rate mortgage has a higher starting interest rate does not indicate that this is a worse form of borrowing compared to the adjustable rate mortgages. If interest rates rise, the ARM cost will be higher while the FRM will remain the same. In effect, the lender has agreed to take the interest rate risk on a fixed-rate loan. Some studies have shown that the majority of borrowers with adjustable rate mortgages save money in the long term, but that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs. In each case, a choice would need to be made based upon the loan term, the current interest rate, and the likelihood that the rate will increase or decrease during the life of the loan.
The traditional fixed rate mortgage is the most common type of mortgage loan programs, where monthly principal and interest payments never change during the life of the loan. About 75% of all home loans applicants or refinancers seek fixed rate mortgages annually. Fixed rate mortgages are usually in 10, 15, to 30 year terms and can be paid off at any time without penalty. Fixed Rate mortgages are structured, or “amortized” so that it will be completely paid off by the end of the loan term. There are also “bi-weekly” mortgages, which can shorten the loan term because half the monthly payment is made every two weeks. (Since there are 52 weeks in a year, you make 26 payments, or 13 “months” worth, every year.)
Although you have a fixed rate mortgage, your monthly payment may vary if you have an “impound/escrow account”. In addition to the monthly loan payment, some lenders collect additional money each month (from borrowers with less than 20% cash down when they purchased their home for the prorated monthly cost of property taxes and homeowners insurance. The extra money is put in an impound/escrow account by the lender who uses it to pay the borrowers’ property taxes and homeowners insurance premium when they are due. If either the property tax or the insurance happens to change, the borrower’s monthly payment will be adjusted accordingly. However, the overall payments in a fixed rate mortgage are very stable and predictable.
Advantages of Fixed Rate Mortgages
- 1) The homeowner knows the interest rate and monthly payment of their mortgage.
- 2) The homeowner knows when their loan will be paid in full since the term (time span) of their mortgage is fixed.
- 3) It is easier to manage your money when you have a fixed rate mortgage.
- 4) If a home applicant get a fixed or ARM rate mortgage when rates are high, they can refinance the mortgage when rates becomes low, although some closing costs may have to be included.
- 5) However, most of the closing costs can be included in the loan and may be tax deductible for you.
- 6) The interest rate of a fixed rate mortgage usually starts a little higher than an adjustable rate mortgage, which has a potential for the rate to increase.
Know Your Adjustable Rate Mortgages
Adjustable Rate Mortgages (ARM)
In the United States, adjustable-rate mortgage (ARM) refers to a mortgage regulated by the Federal government, with caps on charges. Adjustable-rate mortgage (variable-rate or tracker mortgage) is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets.
The loan may be offered at the lender’s standard variable rate/base rate with a direct and legally-defined link to the underlying index. Where there is no specific link to the underlying market or index the rate can be changed at the lender’s discretion. The term “variable-rate mortgage” is most common outside the United States, whilst in the United States; “adjustable-rate mortgage” is most common.
Some common indies are:
1) The rates on 1-year Constant Maturity Treasury (CMT) Securities.
2) The Cost of Funds Index (COFI), and
3) The London Interbank Offered Rate (LIBOR).
A few lenders use their own cost of funds as an index, rather than using other indices to ensure a steady margin for the lender, whose own cost of funding is usually related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). On the other hand graduated payment mortgage offers changing payment amounts but maintains a fixed interest rate. Other forms of mortgage loan include the interest only mortgage, the fixed rate mortgage, the negative amortization mortgage, and the balloon payment mortgage.
Adjustable rates transfer part of the interest rate risk from the lender to the borrower which they used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate goes down (falls) but loses if the interest rate rises (increases). The borrower also benefits from reduced margins to the underlying cost of borrowing compared to fixed or capped rate mortgages.
A mortgage loan in which the interest rate changes after a fixed period of time from loan initiation is called an adjustable rate mortgage or ARM. ARM are consider riskier mortgages to the borrower because a rate change may negatively impact the homeowner that walks away due to inability to handle the new payment
The initial rate on an ARM is lower than on a fixed rate mortgage which allows you to afford a better home. Adjustable rate mortgages are usually amortized over a period of 30 years with the initial rate being fixed for anywhere from 1 month to 10 years.
All ARM loans have a “margin” plus an “index.” Margins on loans range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property value. The index is the financial instrument that the ARM loan is tied to such as: 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI).
When the time comes for the ARM to adjust, the margin will be added to the index and typically rounded to the nearest 1/8 of one percent to arrive at the new interest rate. That rate will then be fixed for the next adjustment period. This adjustment can occur every year. However, there are factors limiting how much the rates can adjust. These factors are called “caps”. Suppose you had a “3/1 ARM” with an initial cap of 2%, a lifetime cap of 6%, and initial interest rate of 6.25%. The highest rate you could have in the fourth year would be 8.25%, and the highest rate you could have during the life of the loan would be 12.25%.Some ARM loans have a conversion feature that would allow the borrower to convert the loan from an adjustable rate to a slightly higher fixed rate than the market rate with a minimal charge to convert by refinancing.
Advantages of Adjustable Rate Mortgages
- 1) Adjustable rate mortgages (ARMs) generally permit borrowers to lower their initial payments if they are willing to assume the risk of interest rate changes in the future.
- 2) For the borrower, adjustable rate mortgages may be less expensive, but it comes at the price of bearing higher risk later
Components of Adjustable Rate Mortgages
To understand an ARM, you must have a working knowledge of its components. Those components are:
Index: A financial indicator that rises and falls, based primarily on economic (market) fluctuations. Index is usually an indicator and is therefore the basis of all future interest adjustments on the loan. Mortgage lenders currently use a variety of indexes.
Margin:A lender’s loan cost plus profit. The margin is added to the index to determine the interest rate because the index is the cost of funds and the margin in the lender’s cost of doing business plus profit
Initial Interest: The rate during the initial period of the loan, which is sometimes lower than the note rate. This initial interest may
be a teaser rate, an unusually low rate to entice buyers and allow them to more readily qualify for the loan.
Note Rate: The actual interest rate charged for a particular loan program
Adjustment Period: The interval at which the interest is scheduled to change during the life of the loan (e.g. annually).
Interest Rate Caps:Limit placed on the up-and-down movement of the interest rate, specified per period adjustment and lifetime adjustment (e.g. a cap of 2 and 6 means 2% interest increase maximum per adjustment with a 6% interest increase maximum over the life of the loan).
Negative Amortization: Occurs when a payment is insufficient to cover the interest on a loan. The shortfall amount is added
back onto the principal balance
Convertibility: The option to change from an ARM to a fixed-rate loan. A conversion fee may be charged.
Carryover: Interest rate increases in excess of the amount allowed by the caps that can be applied at later interest rate
adjustments (a component that most newer ARMs are deleting).
Teaser Rate Periods
Many ARMs have “teaser periods”, which are relatively short initial fixed-rate periods (typically one month to one year). During this period the ARM bears an interest rate that is substantially below the “fully indexed” rate. The teaser period may induce some borrowers to view an ARM as more of a bargain than it really represents. A low teaser rate predisposes an ARM to sustain above-average payment increases.
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