Types of Mortgages

A Fixed-Rate Mortgage:

Is a mortgage in which the interest rate does not change during the entire term of the loan

These mortgages are offered in various terms

  • Commonly 15 years or 30 years
  • The only change in payments a borrower may incur would be an increase or decrease in the amounts the lender collects for:
    • Mortgage insurance
    • Real estate taxes
    • Or property insurance (escrow payments)

A Fixed-rate “amortizes” the money borrowed over the stated term by:

  • Paying the interest due
  • Reducing the principal a little each month

In the early years:

  • Most of the monthly payment goes toward interest
  • Very little goes toward the principal.

In the later years:

  • Most of the payment goes toward principal
  • Very little toward interest
  • For example:
    • $70,000 30-year mortgage, at 10%
    • First Payment
      • Interest: $583.33
      • Principal: $30.97
    • Final Payment
      • Interest: $5.08
      • Principal: $609.22
    • Total Pmt: $614.30 Total Pmt: $614.30
15-year Fixed-Rate Mortgage – 
  • Reduces the total amount of interest paid over the life of the loan by accelerating the principal reduction
  •  Compare the principal paid in the above example (first payment) with the principal paid in the example below:
    • $70,000 15-year mortgage, at 10%
    • First Payment
      • Interest: $583.33
      • Principal: $168.89
    • Total Pmt: $752.22
  • By choosing the 15-year term instead of the 30-year term, the borrower will:
    • Payoff his loan in half the time
    • And save over $85,000 in total interest costs
    • Of course, the monthly payments will be higher than the 30-year fixed payments
30-year Fixed-Rate Mortgage – 

Some borrowers may choose a 30-year fixed-rate mortgage and prefer to “pre-pay” additional principal to reduce the loan balance faster. In the above example, let’s assume the borrower wishes to increase his monthly payment by and extra $50 every month:

  • First Payment
    • Interest: $583.33
    • Principal: $80.97
    • Total Pmt: $644.30
  • This additional $50 each month will:
    • Shorten the term of the loan to just over 21 years
    • Reduce the total interest paid over the life of the loan by almost $53,000.
  • As a borrower’s income increases over the 30-year period, the mortgage payment remains the same on a fixed-rate loan
    •  This means that the borrower’s housing expense will become a smaller percentage of higher gross income over time.

An Adjustable Rate Mortgage (ARM):

Is a mortgage in which the interest rate changes at predetermined intervals, usually every 12 months (1-year ARM).

The interest rate will increase or decrease based upon an index which reflects the current money market rate.

The most common ARM loans tie the interest rate to increases or decreases in the “One-Year Treasury” index.

The change in the interest rate will also change the borrower’s monthly payment. The term of these loans are usually 30 years.

To protect homeowners from “payment shock” (huge increases in payments) almost all ARMs have payment “caps”:

  • These caps limit the rate increases to either 1% or 2% per year.
  • In addition, lifetime caps of either 5% or 6% provide maximum increase limits.
  • For example, an 8% ARM with 2/5 caps would mean that the interest rate could not increase by more than 2% in any one year, or 5% over the lifetime of the loan.
    • In this case the interest would never exceed 13%.
    • If the index decreases, the interest rate on an ARM will decrease, resulting in lower monthly payments for the borrower.

ARMs are offered at a lower initial starting rate usually between 1% and 1.5% lower than a fixed-rate loan.

  • This lower interest rate may help a borrower qualify for a mortgage, because the resulting monthly payment will also be lower.

ARMs may be more economical if a borrower is planning on owning the home for only a few years, as they offer lower starting rates and lower monthly payments.

Large Down Payment – Thing of the Past, But May Be Coming Back

  • In the past, lenders typically required a 20% down payment on mortgage loans
  • The large down payment or borrower equity was required because it helped assure lenders that borrowers would make the monthly mortgage payments to protect the equity they had invested in the home

Private Mortgage Insurance (PMI):

Now, however, with private mortgage insurance (PMI), lenders are more willing to make loans with less than 20% down.

  • This is because the mortgage insurance acts as a guarantor and shares in some of the lending risk with the lender
  • If the borrower defaults on the mortgage loan and the lender takes title to the property, the mortgage insurance will reduce or eliminate loss to the lender.
    • In other words, if the lender has to take the property back because the loan is not being repaid, the mortgage insurance company will absorb part of the lender’s financial loss.
  • For instance:
    • Some first-time home buyers may think a 20% down payment is required and as a result will postpone their decision to purchase
    • Or they may buy a smaller house with the intention of moving up to a larger home sometime in the future
    • However, in many cases they could purchase a larger, more suitable home, simply by selecting a lower down payment loan
    • Other buyers may delay purchasing home furnishings or landscaping because they think that making a 20% down payment is a standard practice.
      • Again, by putting less money down, they will have more cash available for the extra “touches” that make a house a home

The 1986 Tax Reform Act may also affect your home finance decision, as it began the phase out of the interest deduction on consumer loans.

  • This means that the interest you pay on items are no longer deductible, such as:
    •  Your auto loan
    •  Education loans
    •  Etc.
    • Because of this, you may choose to put less money down on your home and use the remaining cash to:
      • Purchase large consumer items
      • Save for future financial needs, like college expenses
      • Make investments
      • Purchase home furnishings
      • Pay off all other debt