Mortgage Rate Options
Fixed Rate Mortgages
The most commonly used loan program is the traditional fixed rate mortgage, where the borrower makes consistent monthly payments of principal and interest that remain unchanged throughout the loan term. This mortgage type is available in terms of 10 to 30 years, and borrowers can usually pay it off without penalty. The mortgage is structured to be fully amortized by the end of the loan term.
Although the interest rate remains fixed, the monthly payment may fluctuate if the borrower has an “impound account.” Some lenders collect additional funds each month to cover the prorated cost of property taxes and homeowners insurance. The extra money is deposited into an impound account, which the lender uses to pay the borrower’s property taxes and insurance premium when they become due. If there is a change in property tax or insurance cost, the monthly payment will be adjusted accordingly. Nonetheless, overall payments in a fixed rate mortgage are typically steady and foreseeable.
Adjustable Rate Mortgages (ARMs)
Loans known as Adjustable Rate Mortgages (ARMs) have an interest rate that can vary over the loan’s duration. These loans commonly offer a fixed interest rate for a certain period, after which it can change according to the current market conditions. The initial rate for an ARM is usually lower than a fixed-rate mortgage, enabling borrowers to buy more expensive homes. ARMs usually amortize over 30 years, with the initial rate fixed for a duration ranging from 1 month to 10 years. All ARM loans have an “index” and a “margin.” The margin on a loan ranges from 1.75% to 3.5%, based on the index and the loan’s amount financed compared to the property value. The index is the financial instrument to which the ARM loan is linked, including 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 an ARM loan adjusts, the margin is added to the index, and then the new interest rate is typically rounded to the nearest 1/8 of one percent. This new rate will be fixed for the next adjustment period, which can be yearly. However, there are limits on how much the rates can adjust, which are called “caps.” For instance, a “3/1 ARM” with an initial cap of 2%, a lifetime cap of 6%, and an initial interest rate of 6.25% could have a maximum rate of 8.25% in the fourth year and a maximum rate of 12.25% during the loan’s term.
Interest Only Mortgages
When a mortgage loan’s monthly payment only covers the interest and not the repayment of principal for a specific period, it is called an “Interest Only” mortgage. This type of loan is available on fixed rate mortgages, adjustable rate mortgages (ARMs), and option ARMs. Once the interest-only period ends, the loan becomes fully amortized, resulting in higher monthly payments than if it had been fully amortizing from the start. The longer the interest-only period, the larger the increase in the monthly payments when the period ends.
During the interest-only term, the borrower won’t build equity in the property but may be able to afford a more expensive home. By qualifying for the loan based on the interest-only payment and refinancing before the interest-only term expires, the borrower could effectively lease their dream home now and invest the principal portion of the payment elsewhere while realizing the tax advantages and appreciation that come with homeownership.
For instance, if you borrow $250,000 at 6% using a 30-year fixed-rate mortgage, your monthly payment would be $1,499. However, if you borrowed $250,000 at 6% using a 30-year mortgage with a 5-year interest-only payment plan, your initial monthly payment would be $1,250, saving you $249 per month or $2,987 per year. But when the sixth year arrives, your monthly payments will increase to $1,611, or $361 more per month. Ideally, your income would have increased accordingly to support the higher payments or you have refinanced your loan by then.
Although mortgages with interest-only payment options can save money in the short-term, they tend to cost more over the 30-year term of the loan. However, most borrowers pay off their mortgages well before the full 30-year loan term.
Borrowers with sporadic incomes could benefit from interest-only mortgages, especially if the mortgage allows the borrower to pay more than interest-only. In this case, the borrower can pay interest-only during lean times and use bonuses or income spurts to pay down the principal.