When you're shopping for a new home or looking to refinance your existing home loan, it's very important to choose a mortgage that will fit into your budget. The most common types of mortgage are fixed rate mortgage and adjustable rate mortgage.
When you have a fixed rate mortgage, you know that your payment will be the same now, ten years and twenty years later. The mortgage payment is constant over time because the interest rate is fixed. On the other hand, an adjustable rate mortgage is a mortgage which has an interest rate that changes periodically. When you choose an adjustable rate mortgage, you accept the risk of changing interest rate over a period of time. The more risks you accept, the lower your initial interest rate will be. The more adjustments stated in the loan mean that the risks will be higher.
It is very important to understand the two factors that affect the interest rate. The 2 factors are: the index and the margin. The commonly used indexes are the London Interbank Offered Rate (LIBOR) and the US Constant Maturity Treasury (CMT). The interest rate is dependent on the the current financial market conditions, which is why the ARM interest rate can change at each adjustment period. The margin is the percentage that can be added to the index.
All ARMs have rate caps. Caps decide how much the interest rate can increase or decrease at each adjustment and over the life of your loan. For example, a 10/1 ARM with a 5/2/5 cap structure means that for the first 10-years the rate is unchanged, but on the 11th year (the date of first adjustment), your rate can increase by a maximum of 5% above the initial rate. Every year after, your rate can adjust a maximum of 2%. But your rate can never be more than 5% throughout the life of the loan.
All ARMs have adjustment periods that determine when and how often the interest rate can change. There is an initial period during which the interest rate doesn't change - this period can range from 6 months to as long as 10 years. After the initial period, most ARMs adjust the interest rate periodically.
Borrowers choose the adjustable rate mortgage because of the following reasons:
- They cannot afford the higher interest rate of a fixed mortgage.
- They believe that they can finish paying the property off before the rate moves to variable.
- They believe that the interest rate will not move up over time.
- They do not anticipate staying in the property past the period where the ARM is fixed. They either expect to move to another location or a house upgrade before the interest rate changes.
- They leverage an interest only ARM which only requires interest payments on the loan and will have lower interest rates as well; thereby, keeping monthly payments to a minimum.
There are 3 main types of adjustable rate mortgages:
Interest-Only ARM only requires borrowers to pay interest of the loan rather than principal + interest. This will result to a smaller payments for the duration of the interest only period. However, it does not decrease your outstanding principal balance. After the interest-only period, the borrower will be responsible for fully amortizing the loan over the amortization period. This will substantially increase the monthly payments after the initial interest-only period lapses. For example, if you take out a 7/1 interest only ARM on a 30 year amortization schedule, you are taking a fixed rate interest only loan for 7 years and will be required to amortize the outstanding principal balance over the next 23 years at an adjustable rate (which can change every year).
Hybrid ARM blends the characteristics of a fixed-rate mortgage an adjustable-rate mortgage. This type of mortgage will have an initial fixed interest rate period followed by an adjustable rate period. After the fixed interest rate expires, the interest rate starts to adjust based on an index plus a margin.
Payment-Option ARMs which allows the borrower to choose between several monthly payment options: a 30 or 40-year fully amortizing payment, a 15-year fully amortizing payment, an interest-only payment, a minimum payment or any amount greater than the minimum payment. Minimum payments accept less than the interest expense charged to the loan. 30-year amortizing payments pay off the mortgage in thirty years. Interest-only payments pay interest upon the loan---without reducing any mortgage principal.
Mortgage is essential in the home buying process. With some planning, you can choose a mortgage that saves you money. Consult with a Mortgage Professional which mortgage type is more suitable for you.
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