Buying a home is the single largest purchase most people will ever make and, with interest rates at historic lows, first-time homebuyers are seeking out opportunities in record numbers. For newcomers, the financing process can seem especially confusing and complex. Here is a brief guide to help you find a mortgage that best suits your needs and financial goals.
The two basic mortgage types are fixed rate mortgages and adjustable rate mortgages (ARMs). Deciding which is right for you depends on a number of factors: the spread between the prevailing fixed and variable mortgage rates; the length of time you expect to own your home; the current inflation rate; and the tax savings you expect to receive from the home mortgage interest deduction.
Fixed Rate Mortgages
A fixed rate mortgage is characterized by the following: an interest rate that remains the same for the life of the loan; level monthly payments; and a principal that will be fully repaid at the end of the loan. The total amount of interest you will pay on a fixed rate mortgage increases with the term, which generally ranges from 15 to 30 years.
One major benefit of a fixed rate mortgage is the certainty of knowing your monthly payments will not increase over the life of the loan, even if interest rates rise. On the other hand, the chief disadvantage is that if interest rates drop, your monthly payment will not decrease. The only way you will be able to take advantage of a drop in interest rates is to refinance the loan, which may be a costly transaction.
Adjustable Rate Mortgages (ARMs)
An adjustable rate mortgage carries an interest rate that a lender can vary during the loan term. ARMs are designed to shift the risk of rising interest rates from the lender to the borrower. To offset the increased interest rate risk, ARMs usually offer borrowers a lower rate—compared to a fixed rate mortgage—during the first year. If you are considering an ARM, you will probably encounter the following terms:
The adjusted effective rate is the rate you pay when the adjustments kick in. It is calculated as the value of the index specified in the loan agreement plus the margin. For example, if the index value rises to 8% and the margin is 2%, the adjusted effective rate is 10%. (The adjusted effective rate is not the same as the annual percentage rate (APR), which includes the points levied on the mortgage.)
- Index. An index is a benchmark used by a lender to adjust an ARM’s interest rate. Commonly used indexes include the rate on U.S. Treasury securities and the average cost of federally insured savings and loan funds.
- Margin. Also called the “spread.” This is the amount a lender can add to the value of the index specified in the loan agreement.
- Initial Rate and Adjusted Effective Rate. The initial rate is the interest rate at the start of the mortgage. It is typically lower than the amount you would owe on a fixed rate mortgage. Very low initial rates, called “teasers,” are designed to persuade you to enter into the loan.
Understand Your Options
- Adjustment Period. This is when mortgage payments or interest rates may change every six months, annually, or every three years.
- Caps. ARMs may include several kinds of caps. A payment cap limits the increase in monthly payments at each adjustment period. An interest adjustment cap limits the amount by which the interest rate can rise or fall at each adjustment period. A lifetime interest cap limits the maximum interest the lender can charge during the loan term. A lifetime payment cap limits the percentage by which principal and interest payments can increase during the loan term.
- Negative Amortization. This occurs when your mortgage payment is less than the amount necessary to cover the interest on the loan. As a result, the unpaid interest is added to the loan principal. The loan agreement may cap the amount of negative amortization allowable.
There is no one “right” way to finance a home. All financing arrangements involve tradeoffs. The more you know about your options, the better able you will be to arrange a mortgage that suits your needs.