When you shop for a mortgage loan to finance your new home purchase, commonly there are two basic types: fixed rate mortgage and adjustable rate mortgage.
There is no single right loan, since every home buyers circumstance and risk factor differ.
Fixed Rate Mortgage
Fixed Rate Mortgage is a mortgage loan where the interest rate on the note remains the same through the term of the loan.
The calculation of the monthly payment, or loan amortization, is computed from the interest rate, compounding frequency, loan amount, and term of the mortgage.
This monthly payment amount is independent of the additional costs on a home sometimes handled in escrow, such as property tax and home insurance.
Consequently, total costs to borrowers may change over time with the changing escrow amount, but the payments handling the principal and interest on the loan will remain the same.
The advantage of the fixed rate mortgage is that the payment is the same each month, thus reduces your risk with payments fluctuating. The disadvantage is that the interest is generally a little higher than an adjustable rate or interest only loan.
Adjustable Rate Mortgage
Adjustable Rate Mortgage (ARM) is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices.
Adjustable rate mortgages are characterized by their index and limitations on charges or caps.
The advantage of an adjustable rate mortgage is that the rate and monthly payments are usually lower than a fixed rate mortgage. The disadvantage is that borrowers take risk of interest rate moving up, thus suddenly increasing monthly payment.
Basic features of Adjustable Rate Mortgage loans are:
- Initial interest rate. This is the beginning interest rate on an Adjustable Rate Mortgage.
- Adjustment period. This is the length of time that the interest rate or loan period on an Adjustable Rate Mortgage is scheduled to remain unchanged.
- Index rate. Lenders base ARM rates on a variety of indices, the most common being rates on 1-, 3-, or 5-year Treasury securities, national or regional average cost of funds to savings and loans.
- Margin. This is the percentage points that lenders add to the index rate to determine the ARM’s interest rate.
- Interest rate caps. These are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan.
- Initial discounts. These are interest rate concessions, often used as promotional aids, offered the first year or more of a loan.
- Conversion. The agreement with the lender may have a clause that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times.
Adjustable Rate Mortgage types
Hybrid Adjustable Rate Mortgage Hybrid ARM features an interest rate that is fixed for an initial period of time, then adjusts thereafter. The hybrid refers to the ARM’s blend of fixed-rate and adjustable-rate characteristics. Hybrid ARMs are referred to by their initial fixed-rate and adjustable-rate periods, for example 5/1 ARM with a 5-year fixed interest-rate period and subsequent 1-year interest-rate adjustment periods.
Option Adjustable Rate Mortgage Option ARM is typically a 30-year ARM that initially offers the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, and a 30-year fully amortizing payment. These types of loans are also called pick-a-payment or pay-option ARMs.
Cash Flow Adjustable Rate Mortgage Cash flow ARM is a minimum payment option mortgage loan and allows a borrower to choose their monthly payment from several options. These payment options usually include the option to pay at the 30 year level, 15 year level, interest only level, and a minimum payment level.
The minimum payment level is usually lower than the interest only payment. This type of loan can result in negative amortization. The option to make a minimum payment is usually available only for the first several years of the loan.
Prepayment of Mortgage Loan
Adjustable rate mortgages, fixed rate mortgages, and other types of mortgages usually allow the borrower to prepay principal early without penalty.
Early payments of part of the principal will reduce the total cost of the loan or interest paid.
With a fixed rate mortgage, early payments will shorten the amount of time needed to pay off the loan.
With an adjustable rate mortgage, early payments will not shorten the amount of time needed to pay off the loan. Upon each recasting, the new fully indexed interest rate is applied to the remaining principal to end within the remaining term schedule.
Ask lenders about prepayment penalties. Prepayment terms are negotiable.
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