In this article we go over fixed rate and adjustable rate mortgages and what home loan options are available.
Fixed Rate Mortgages
Fixed rate mortgages offer the following term options as a general rule:
- 30 year
- 20 year
- 15 year
- 10 year
For many, a fixed rate term seems the safest loan type. You know how many years you’ll pay, you know the rate, and other than fluctuations in insurance, and taxes, your payment will be pretty stable through the life of your home loan. If you want to pay off the loan faster, you can ask about bi-monthly payments or sending in extra cash towards principal when you want. Just make certain there are no prepayment penalties that could hit you if you actually do pay the loan off before the agreed upon date.
Adjustable Rate Mortgages
As the name implies, adjustable rate mortgages have a rate that adjusts periodically. The rate goes up (or down) depending on the market, based on a schedule dictated by the adjustable terms. Most adjustable rate mortgages are amortized (payment is planned) over 30 years. Common adjustable rate terms include:
- 1 Year
- 3 Year
- 5 Year
While many people think an adjustable rate mortgage is a bad idea, for many it’s a useful way to get a lower rate. With planning, you may never feel the pinch of a higher rate and related payment. Why is this true? Today, the average American moves every 7 years. If you get an adjustable rate mortgage that doesn’t adjust until year 5, and you move as the typical American family does, you will never see that second rate adjustment. Plus, you’ll be able to plan ahead for that adjustment. Another group of people for whom an adjustable rate mortgage might make sense to, is someone just starting off in a career. If you’re building a portfolio of clients or you know your salary will be higher in another 2 – 3 years, the thought of a payment going up later may not be as scary for you.
Rate Reset – Adjustable rate mortgages have a fixed rate for a period of time (the loans term) and then the rate resets when the fixed rate period ends, the rate will be reset based on a combination of the index and margin rules that are referred to in your loan documents.
Numbers to look for when considering an adjustable rate mortgage are:
Index – Common mortgage index rates include:
- 1 year T bill
- 1 Year CMT
- Overnight Libor
Rates are published in the Wall Street Journal and other sites, and can be monitored throughout the life of your loan.
Margin – This is the amount a lender will add to your index to arrive at your rate. Your rate will be reviewed at a predetermined date and using a calculation of index plus margin, your rate will be reset. If it’s a 3 year, they’ll calculate the rate at the three year mark, if it’s an annual adjustable the rate will be reviewed annually, etc.
Caps – Caps indicate the maximum amount of rate adjustments. Some loans have floor and ceiling caps, letting you know the lowest and highest a rate can go.
Example: Caps listed as 2/2/6 indicate your first adjustment will not increase or decrease by more than 2%, and then will not increase by more than 2% in any subsequent year. The “6” means your rate will never be higher than 6% of your start rate. With this knowledge, you can run “worst-case scenario” numbers and estimate your new payment when it comes near to your rate change date.
Some loan rates start with an “introductory” discount. You’ll see this if you apply for a loan with a rate significantly below the index and margin today. Lenders offer these discounted rates in order to compete for your business.
Some mortgages start with a longer fixed period and then switch to an annual adjustment. These include the 3/1, 5/1 and 7/1 adjustable loans. With these, the rate remains locked for that first number (3 years, 5 years, or 7 years) and then adjusts, with additional adjustments happening yearly. Some first time homebuyer mortgages even offer 5/5 arrangements where the mortgage rate adjustments will happen at 5 year intervals.
First Time Homebuyer Options
There are numerous home loan options available for first-time homebuyers. Some offer short term low rates, with stepped rate increases, some offer longer intervals between rate adjustments, and some offer other benefits like no PMI, $0 or minimal down payment requirements, discounted closings costs, etc. Many lenders have their own special First Time Homebuyer programs. Two organizations that offer popular programs for first-time homebuyers include:
FHA/VA Home Loans – FHA and VA loans are supported through different agencies whose goal it is to assist people in achieving the dream of home ownership. They offer a variety of loan types and resources to walk you through the steps of applying for a mortgage, refinancing a home, and understanding the process. Loan applicants taking advantage of FHA loans must meet certain income requirements, and housing guidelines in order to benefit from their programs.
Understanding the variety of home loan options available is important. One that works for you may be different than one your parents or friends would choose. Understand the options available, and how they work in order to make the best decision on a loan to pay for your new home.