Mortgage Basics
Source: Freddie Mac's Online Guide to the Homebuying Process
Adjustable-Rate Mortgages
Adjustable-rate mortgages (ARMs) are popular because they usually start with
a lower interest rate and a lower monthly payment. The lower rate (and lower
monthly payments) may also allow a higher loan amount. However, the interest
rate can change during the life of the loan, which would mean that your monthly
payment would increase (or decrease).
It's important to understand the specifics of an adjustable-rate mortgage,
commonly called an ARM:
- Adjustment periods.
All ARMs have adjustment periods that determine when and how often the interest
rate can change. There is an initial fixed-rate period during which the interest
rate doesn't change - this period can range from as little as 1 month to as
long as 10 years. After the initial period, the interest rate will often adjust
each year. For example, with a 3/1 ARM, your interest remains the same during
the first 3 years, and then can adjust every year following, up to a maximum
amount (the "lifetime cap").
- Indexes and margins.
At the end of the initial period and at every adjustment period,
the interest can change based on two factors: the "index" and the margin.
Interest rate adjustments are based on a published index. There are many indexes
but some commonly used for ARMs are the LIBOR and the U.S. Treasury Bill.
The rates for indexes reflect current financial market conditions, which is
why your interest rates can change at each adjustment period. The margin is
the amount (shown as a percentage) that is added to the index to determine
what your new mortgage rate will be until the next adjustment period.
- Caps, ceilings, and floors.
All ARMs have rate caps, also known as ceilings and floors. Caps
decide how much the interest rate can increase or decrease at each adjustment
period and over the life of the loan. Most ARMs have a lifetime cap that limits
the amount your interest rate can increase over the life of your mortgage.
- The number system.
There are several types of ARMs, such as the 10/1, 7/1, 5/1 and 3/1. The first
number (10 for example) is the length of the initial period, during which
the interest rate can't change. The second number (1 for example) is how often
the ARM is adjusted after the initial period. So, a 10/1 ARM won't change
for the first 10 years, but can change in the 11th year and again every year
after that. Depending on the initial cap the change could be as high as 5
percentage points above what it was before.
There are additional considerations to be aware of with adjustable-rate mortgages:
- Because the initial interest rate is usually lower than a fixed-rate mortgage,
your initial payments will be lower and you may qualify for a larger mortgage
amount.
- If interest rates are high when you get your mortgage but drop during
any adjustment period, your monthly payment may decrease.
- An ARM with a low
initial interest rate and an initial adjustment period after 5 or 7 years
can save you money.
- ARMs can, and often do, have interest rate increases
at adjustment periods. You may have an increase in your monthly mortgage payment
after each adjustment period. The amount your mortgage might increase would
depend on the periodic cap (how much of an increase is allowed each year),
the lifetime cap (the maximum interest rate or maximum number of increases
allowed), and the size of your mortgage's margin. If the life cap is 5%, the
maximum interest rate adjustment would be to 10.75%
Balloon/Reset Mortgages
Balloon/reset mortgages have monthly mortgage payments based on a 30-year amortization
schedule, and you have a choice at the end of the 5- or 7-year term to either
pay off the remaining balance or reset the mortgage. So you have the advantage
of a low monthly payment, like someone with a 30-year loan, but you must pay
off the loan at the end of the specified term.
Many balloon mortgages have a "reset" option. That means you can reset the
interest rate of your mortgage to the current market rate for the remainder
of the amortization period. This option is typically only available if:
- You're still the owner and occupant of the home.
- You've paid your mortgage
on time for at least a year prior to the balloon note maturity date.
- You
have no other liens against the property.
- If you do not qualify for a reset,
you may qualify to refinance your balloon/reset mortgage.
There are additional considerations to be aware of with balloon/reset mortgages:
- If you plan to sell your home before the balloon maturity date of the
balloon/reset mortgage, this type of mortgage, like an ARM, may be a good
option.
- Balloon/reset mortgages usually come with a slightly lower initial
rate than most other fixed-rate mortgage types. You may qualify for a larger
loan amount with a balloon/reset mortgage than you would with a fixed-rate
mortgage.
Unlike ARMs, whose interest rates may reset or adjust a number of
times over the loan's life, a balloon mortgage comes with only adjustment.
However, if interest rates rise sharply during the term of the balloon loan,
you could face a large increase in your monthly payments when you reset or
refinance your mortgage.
- If your financial condition has changed at the end
of the balloon term because of a decline in income, family medical problem,
etc., you may have difficulty refinancing into an acceptable new mortgage.
What the numbers mean. There are 2 types of balloon/reset
mortgages: 7/23 and 5/25. The two numbers together are the total number of years
(30) the payments will be based on. The 1st number (7 or 5) is the number of
years before the balloon maturity date. The 2nd number (23 or 25) is the balance
of the term.
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