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MORTGAGE RATES
Mortgages can have either fixed or adjustable rates, or sometimes a hybrid of the two.
You can often choose the method that's used to figure interest on your mortgage. With
a fixed-rate loan, the total interest you'll owe is determined at closing.
With an adjustable loan, the rate you pay changes as the cost of borrowing
changes.
FIXED-RATE MORTGAGES
Fixed-rate
or conventional mortgages have been around since the 1930s. The
total interest and monthly payments are set at the time the sale is finalized.
You repay the principal and interest in equal, usually monthly, installments
over a 15-, 20- or 30-year period. You know right from the start what
you'll pay and for how long.
In most cases, though, you can choose to prepay your mortgage before the
term is up, which means you'll owe less interest. Or you can renegotiate
the loan to get a lower rate. However, with some loans, you may owe a
prepayment penalty. That charge will be explained in your loan agreement.
ADJUSTABLE-RATE MORTGAGES
Adjustable-rate mortgages (ARMs) were introduced
in the 1980s to help more buyers qualify for mortgages, and to protect
lenders by letting them pass along higher interest costs to borrowers
if rates went up during the term of the loan.
HOW ARMs WORK
An ARM has a variable interest rate: The rate changes
on a regular schedule — such as once a year — to reflect fluctuations
in the cost of borrowing. Unlike fixed-rate mortgages, the total cost
of borrowing can't be figured in advance, and monthly payments may rise
or fall over the term of the loan.
Lenders determine the new rate using two measures:
- An index, which is often
a published figure, like the rate on US Treasury bills or the cost-of-funds
index from the Office of Thrift Supervision. Be sure to find out which
index your lender uses, since some fluctuate more — and change
more rapidly — than others.
- A
margin, which is the number of basis points or hundredths
of a percentage point, added to the index to determine the new rate.
CAPPED COSTS
All ARMs have caps, or limits, on the amount
the interest rate can change. An annual cap limits the rate change
each year (usually by two percentage points), while a lifetime cap
limits the change over the life of the loan (typically to five or six percentage
points).
Be careful: Lifetime caps are often based on the actual
index plus margin and not on the introductory rate. For example, with a
3.5% teaser rate and a 6% actual interest index plus margin, your
rate could go as high as 12.5% with a six-point lifetime cap.
NEGATIVE AMORTIZATION
With certain types of loans, you may be faced with the possibility of
negative amortization. In that case, you may owe more than you expected
before the mortgage ends, because interest rates have moved higher than your
cap allowed the lender to charge you.
Put simply, if interest rates rise 5% one year, but your annual cap
is 1%, you still owe the 4% difference. The additional interest
is added to the amount of your loan. Eventually, the term may be extended,
requiring extra payments to cover the money you owe.
If negative amortization applies to your loan, typically the most
that can accumulate is 125% of the original loan amount. Then some resolution
must be arranged, such as a lump sum payment or loan extension.
You may also encounter negative amortization if you take an interest only loan or a loan that allows you to make variable payments as long as you pay something each month. While these mortgages may seem attractive, you do need to be aware of their potential drawbacks.
TEASER RATES
The introductory rate
you pay for the first months of an adjustable-rate mortgage is almost always
lower than the actual cost of borrowing the money. What
it means for the borrower is not only a few months of relief but also lower
closing costs. The effect is to make mortgages more accessible to more people.
What it means for the lender is being able to adjust the rate upward
within a few months while staying competitive with other lenders.
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