July 5, 2009 by  
Filed under Mortgage Updates

mortgageWhen shopping for a mortgage, consumers have more choices than ever before. Many lenders now offer specialty mortgages that help make homeownership more affordable but have risks that consumers should fully consider (see our brochure on specialty mortgages). But for most consumers, the traditional fixed-rate mortgage and adjustable-rate mortgage (ARM) continue to be excellent options. However, even these traditional financing options require a number of important decisions. Should you get a 15- or 30-year loan? Should you get a fixed-rate mortgage to lock in today’s interest rates for the term of the loan—or take an adjustable-rate loan with a lower current rate and payment, but with the risk of rate and payment increases in the years ahead?

You can also tap the equity in your home by refinancing your existing mortgage, taking out a second mortgage, or obtaining a home equity line of credit. This brochure helps you consider these options as well.

We hope this brochure will help you understand traditional mortgages and make the choice that is best for you.

Fixed-rate mortgages

With a fixed-rate mortgage, you are guaranteed the same interest rate over the life of the loan. Your monthly payments never change, and the loan is paid off completely over the term you select.

The key choice involves how long you have to pay back the loan. The most common options are 15- and 30-year loans, with the 30-year being the most popular. As this chart illustrates, a shorter-term loan comes with both a lower interest rate and higher monthly payments (so that you pay the loan back faster). Rates, and the differences between rates for 15- and 30-year loans, change daily.
15-Year 30-Year
Interest rate 5.5% 6%
Amount financed $200,000 $200,000
Monthly payment $1,634 $1,199
Loan balance after 5 years $150,578 $186,109
Loan balance after 10 years $85,553 $167,371

Adjustable-rate mortgages

The initial interest rate on an adjustable-rate mortgage (ARM) is generally lower than that for a fixed-rate loan. However, with an ARM, the interest rate may increase or decrease in the future, and the size of your payments will go up or down along with the rate.

Most ARMs are “hybrids,” meaning that the interest rate is “fixed” for a certain number of years—after which the rate begins to “float.” The most common ARMs fix the initial rate for three, five, or seven years. ARMs are probably most appropriate for people who have sufficient financial resources to handle potential payment increases or know that they plan to sell their home around the time the loan’s interest rate is set to change.

Important features of adjustable-rate loans

Before agreeing to an ARM, you should ask the following questions:

How long does the initial interest rate apply?

How frequently can the interest rate change?

How is the adjusted interest rate determined? (Generally, a specified amount—the “margin”—is added to a current published rate—the “index.”)

How high can the interest rate go?

Does the loan set a minimum interest rate?

Are there any limits on how much the interest rate can change each year?

Do the monthly payments still pay off the loan even if interest rates increase? (With some loans, the amount you still owe—your “loan balance”—can increase rather than decrease each month. This is called negative amortization.)

What is the maximum monthly payment that you could be required to pay?

Potential pitfalls of ARMs

Even small changes in your interest rate can increase your monthly payment significantly, resulting in “payment shock.” Even a change of 1% or 2% in interest rates can result in a very big jump in your monthly mortgage payment. For example, if the interest rate on your mortgage changes from 4% to 6%, your monthly payment could rise by as much as 50% (from $1,000 to $1,500).

ARMs can be complicated, and many specialty ARMs (with risky terms appropriate only for a small group of borrowers) are now being marketed widely. Be sure to avoid loans with terms that you don’t understand. Get a copy of our brochure on “Specialty Mortgages: What Are the Risks and Advantages?” to learn more about these ARMs.

Understanding Home Equity

People who have paid down their mortgage or seen their home’s value rise have equity in their home. Equity is the difference between the home’s value and what you owe the mortgage lender. One benefit of homeownership is the ability to build equity. Homeowners draw on equity for emergencies and for retirement income. Equity also allows you to pass wealth (the home or the money made by selling that home) from one generation to the next.

Refinance loans

In recent years, many people have refinanced their home loans to take advantage of low interest rates. Some have also refinanced in order to obtain cash. In a refinance, you pay off your mortgage with a new loan. In a “cash-out refinance,” you increase the size of your debt in order to get cash at the closing table that you can use for other purposes.

In any refinance, it’s important to ask about the fees you will pay. Sometimes, even substantial fees are easily hidden, as lenders may roll the fees into the loan balance. Of course, increasing the loan balance decreases your home equity.

Borrowing against your equity

Many people borrow against their equity. Two options for doing this are a traditional second mortgage and a home equity line of credit.

With both methods, you use your house as collateral—which means that you risk losing your home if you can’t repay the loan according to its terms. The lender decides how much money to make available by considering, in part, how much of the mortgage debt you still owe.

Traditional second mortgage loans

A second mortgage provides a predetermined amount of money that the homeowner is obligated to repay over a fixed period. Second mortgages generally come with fixed interest rates. Home equity lines of credit

A home equity line of credit (HELOC) is a form of revolving credit. Generally, you can borrow up to a certain amount (the “credit limit”) over a predetermined period of time (the “draw period”).

The repayment terms of HELOCs vary. For example, many HELOCs are structured so that monthly payments cover only interest for the first ten years.

A HELOC generally carries a variable rate. If you consider a HELOC, you should ask the same questions about how this rate is set (and may change over time) that you would ask when considering any other adjustable-rate mortgage.

If you sell your home, you will have to pay off or refinance your HELOC.

  • Winsor Pilates

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