Mortgage Rates FYI
Selecting a mortgage is much like buying a car. You think that you know what you want until you arrive at the lot – and the airwaves are filled with ads for “Un-bee-leevable deals!!” that are just what they seem – too good to be true.
If you have selected a home that you want to purchase, you know its asking price. The true cost for that home will, however, be defined by your mortgage rate. Essentially, your mortgage rate is the interest rate that is part of your monthly mortgage payment. With the enormous variety of mortgage types available today, the amount of interest you’re paying on your loan may change from year to year and may fluctuate based on indexes that change based on economic conditions. Thus, for many loans, there is no established monthly “mortgage rate” per se. You can make a stab at calculating the total amount of interest you’ll pay over the life of the loan; that is the best benchmark for comparing mortgages.
Types of Mortgages – and Mortgage Rates
There are two general categories of mortgages – those are fixed rate mortgages and adjustable rate mortgages, or ARMs. The types of ARMs in particular are many and varied; we’ll touch on all of those a little later. There are also some hoops that people go through to get a fixed rate mortgage, and we’ll discuss those as well – because they are a factor in determining what the true cost of your loan is – which is what “mortgage rate” really means.
The Fixed Rate Mortgage
The traditional mortgage that our parents took out on the family home was a “fixed rate” mortgage. This is a home loan at its simplest and most comprehensible. It is a loan with a fixed interest rate – say, seven percent – that remains the same for the life of the loan, which is usually thirty years. A fixed rate loan requires the same payment, every month, for thirty years. Usually included in that payment are a portion of the principal due on the loan, the interest, a monthly installment on property taxes, and homeowners’ insurance premium: known in the trade as PITI. Most lenders reserve fixed rate loans for people with high credit ratings.
Some home mortgage lenders will not grant a fixed rate mortgage to anyone who cannot come up with a twenty percent down payment on the house. That is no longer universally the case, but a twenty percent down payment will also avoid the obligation to pay for mortgage insurance. For many buyers, coming up with 20% of a home’s value in cash is impossible in today’s market. In order to qualify for the fixed rate with no insurance, many people will take out another loan so that their down payment amounts to 20%. This is called a “piggyback loan” and is usually neither a fixed rate loan nor a thirty year note. People who take this path to home ownership are actually taking out two home loans, one of which is a fixed rate thirty year mortgage and the other five to fifteen years at an adjustable rate.
Homebuyers who qualify and opt for a fixed rate loan are choosing financial predictability and typically intend to be in the home for a long time. If they are forced to take out a more expensive second loan in order to qualify for the fixed rate mortgage, the interest costs for that second note must be calculated into the overall mortgage rate on the home in order to get a true “cost of money” figure for the purchase.
Adjustable Rate Mortgages
Adjustable rate mortgages became popular twenty years ago or so, when home prices began to rise beyond the point where down payments could be easily assembled. They also became the option of choice for mortgage lenders with applications from people with less that exemplary credit – which is well over half of us. As the housing market has boomed, the various types of ARMs available has shot up accordingly. Lenders have developed creative ways to get homebuyers into homes, at rates that are affordable – at least initially. Which ARM index is right for you?
A typical ARM will have an initial fixed monthly payment that is lower than a fixed rate mortgage; lately, by one third of a percentage point or less. That rate will maintain for the early years of the mortgage, and then adjust on a yearly basis. Standard ARMs come with three year, five, seven and occasionally ten year initial periods with the low interest rate payment. The mortgage payment then adjusts on an annual basis, based on a couple of factors. These ARMs are referred to as 3/1; 5/1; 7/1; and 10/1 mortgages.
An ARM, when it adjusts, will have a monthly payment based on two factors: the margin and the index. The index is a figure taken from one of several money market measurements: popular examples include the ten year Treasury Bond (T-Bill), the London Inter Bank Offering Rate (LIBOR); the Certificate of Deposit Index (CODI); and the Prime Rate. These are all interest rate figures that fluctuate based on differing sets of market conditions. Thus the LIBOR, which is the interest rate at which British banks offer to loan each other money, may be less volatile than the prime rate or the T-Bill index.
The margin is a flat figure, a percentage amount that is added to the index to determine the new interest rate for the ARM. Generally a margin may be two or three percentage points. So, if an ARM adjusts every January, the borrower’s interest rate for the next twelve months will be the index figure plus the margin. Today’s LIBOR rate is 5.40%; if the ARM has a 3% index, then a mortgage rate adjusted today based on the LIBOR would be 8.40% for the following year. ARMs usually have interest rate caps, sometimes for the annual increase and sometimes for the maximum allowable interest rate and sometimes for both.
The Interest Only ARM
One of the more creative – and potentially dangerous – ARM variants to appear in recent years is the interest-only ARM. This loan is an ARM usually with the same set of options as a standard ARM in terms of timing; the 3/1; 5/1 and 7/1 options still apply. However the initial payment for an interest only ARM consists of just that – a payment that is solely the interest due that month. Moreover, the interest rate will be fixed, as with standard ARMs, at an artificially low rate – less than a fixed rate loan that might be available to a borrower with prime credit.
When an interest only ARM adjusts, it does so based on the same index-plus-margin formula used for standard ARMs. The difference is that payments against the loan’s principal will also be included in the mortgage payment. Under this scenario, the mortgage payment takes a double whammy, as the interest rate jumps and the principal payments begin. If the loan was a thirty year, 5/1 interest only ARM that leaves 25 years to retire the entire principal amount that was borrowed. The resulting jump in monthly mortgage payments can be a real jolt.
The Option ARM
The option ARM was originally created for savvy financial managers who were interested in getting into a home for as little as possible, with every intention of getting out of it before the loan adjusts. However many consumers have chosen the option ARM as well, looking for the lowest possible monthly payment.
An option ARM also has an initial period where the “options” are applicable. Like other ARMs, this period can be three, five or seven years. There are four options for payment available to the borrower each month. He can make a minimum payment, which is less than the interest due. He can make an interest only payment, a standard PITI payment, or a much larger payment that might be designed to make up for several months of minimum payments. This type of mortgage rate works well for people who have erratic income streams.
For those who have normal income streams and choose to make the minimum payment for months on end, the result is “negative amortization.” What this means is that the debt on the home is climbing because the monthly payments do not even cover interest costs. Finally, the homeowner owes more on the house than it is worth and cannot refinance out of the bind. If he is not prepared to deal with the huge jump in monthly mortgage payments when the loan matures, foreclosure looms.
Most mortgage lenders won’t allow the negative amortization to grow beyond 125% of the home’s worth. At that point, the loan will “reset” to reflect the new debt and payments will rise accordingly. The option ARM has been a popular tool for buying as much house as possible; however the buyer that makes this choice had better be anticipating a steady increase in household income. More about Option Arms.
Balloon Payment Mortgages
A balloon mortgage functions like a fixed rate mortgage, with a mortgage payment calculated to pay off the loan in thirty years. However at the end of a specified period – often seven years – the balance of the loan comes due in a lump sum, or “balloon” payment. At this point, the borrower is expected to refinance at whatever the current market rates are, or pay off the loan in full with that recent inheritance.
A balloon payment mortgage is a bet on a reasonable interest rate seven years hence. The value of a loan like this is that it is less complicated than ARMs that have many moving parts and are difficult to understand. The downside is that the only real opportunity to refinance is dictated by the terms of the loan, rather than the market. Refinancing is an expensive process, and getting out of a balloon mortgage early will add considerably to the bottom line. More about Balloon Mortgages.
So What is a Mortgage Rate?
Well, it appears that a mortgage rate can be whatever you can negotiate – and still understand at the end of the process. Part of your mortgage rate should be amortization of loan origination costs, which will be several thousand dollars. If you’re amortizing over five years and intend to refinance, that’s got to go into the calculation of your home’s cost. The number of variables seems many times designed to confuse, so it pays to have a plan for your home purchase and occupancy, and to pay attention. If you can do both, you’ll be able to calculate a true mortgage rate.
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