Loan Rates Explained
Fixed Rate MortgagesA conventional fixed-rate mortgage offers you a set rate and payments that do not change throughout the life or "term", of the loan. A conventional loan is fully paid off over a given number of years, usually 15, 20 or 30. A portion of each monthly payment goes towards paying back the money you borrowed, the "principal", and the rest is "interest". Any money paid into the value of the house, including your down payment, is known as "equity" in the home. For instance, if your house is worth $100,000 and you owe $65,000 on your mortgage, then you are said to have 35% equity in your house.
Temporary Buy-Downs Mortgages"Buydowns" usually refer to a borrower "buying down" the interest rate on a loan. This is the same concept as paying "points" on a loan, except that points buydown (or up) the rate of a loan over the entire term while a buydown is usually only a temporary reduction.
A temporary buydown on a loan is achieved by lowering the rate for the first few years, starting out at a lesser amount and gradually rising to the original loan rate. Of course, because the loan rate is lower for the initial few years, so are the payments. To make up this loss of funds to the lender, the buydown usually consists of extra monies paid up front to the lender when the loan closes. In return, the lender will let the borrower "qualify", or meet the criteria for the loan, at the new, reduced rate.
An example of a temporary buydown on a loan is a 2/1 Buydown. Assume we have a 30-year conventional loan with an interest rate of 9%. A 2/1 buydown would make the interest rate for the first year of the loan equal to 7%, the second year 8% and 9% from then on. The borrower could qualify for the loan (under some loan programs) as if it were a 7% loan.
Balloon Mortgage LoansThis is a special type of conventional, fixed-rate mortgage with a much shorter term. In a balloon mortgage, the terms and payments are usually the same as their conventional loan counterpart, but the balance is due in full on the loan at the end of a specified, much shorter term.
For example, a seven-year balloon mortgage would be calculated to have the same payments as a 30-year loan, with the borrower paying the same amount in interest and principal each month. However, at the end of seven years whatever balance is left on the loan is due. At this point, the borrower may either pay out the loan in full or refinance with a new loan.
Balloons are often priced better than conventional, fixed-rate mortgages because of the certainty to the lender of the mortgage term.
Adjustable Rate Loans (ARM's)An "ARM", or "Adjustable Rate Mortgage" has a fluctuating interest rate and the potential for changing payment amounts. In most ARM mortgages, the interest rate on a loan is fixed for a certain number of years and then allowed to fluctuate in sync with current economic factors.
An ARM is of value to the lender because the risks of lending money in a changing economy are passed on to the borrower. In exchange, most lenders are able to offer a lower initial interest rate to the borrower in exchange for their assumption of this risk.
This is the predetermined period for which the rate of an ARM is adjusted. For instance, a 3/1 ARM has a fixed rate for the first three years of the loan and is then adjusted once every year through the term of the loan to reflect the current economic conditions.
This is a limit specified in the ARM loan for individual and cumulative interest rate adjustments. An example of this is a 2/6 cap, which allows the interest rate on your ARM loan to go up or down by no more than two percent every adjustment period, and has a total limit of six percent for cumulative changes. Therefore a 2/6 cap on a 5% ARM will allow a maximum rate of no more than 11%.
The measurement, or basis, that lenders use to adjust the interest rate on an ARM. ARMs are usually quoted with a "teaser", or first-year rate, and then expressed as an index plus a margin. For instance, a 5/1 ARM may be advertised at 5% with a 2.5% margin over the U.S. 30-year bond index. This means that your first year's rate would be 5%. The second year, the rate would be 2.5% plus whatever the 30-year bond rate was, such as 6%, making your rate through year five equal to 8.5%. In year five, your rate is adjusted again, this time to 2.5% plus the current 30-year bond rate, now 7%, making your new rate equal to 9.5%.
This occurs when the combination of interest rates adjustments and payment caps result in a monthly payment that does not cover the interest portion of your loan. In this case, the difference would be added back to the total amount you owed on the loan, thus making a "negative amortization" to the mortgage.
Convertible Adjustable LoansConvertible ARMs offer the borrower the option to convert the loan from an adjustable-rate to a fixed-rate at specified times during the term of the mortgage. This option is attractive to many buyers who may wish to take advantage of current low interest rates, but want the security of a fixed-rate loan in the future. Be aware of any costs associated with the conversion of the loan.
Questions to Ask When Considering an Adjustable
1. What would the interest rate be today if the rate were fully adjusted, based on the current value of the index?
2. Is there a prepayment penalty?
3. How long before the interest rate can adjust?
4. By what amount can the rate adjust at that time? At the next adjustment period? Over the life of the loan?
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