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Personal and Business Banking

Chapter 5: The Many Flavors of Loans

Mortgage Guide

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  • Article

Chapter 5: The Many Flavors of Loans


  1. The many types of mortgages you may find on the market
  2. The advantages and disadvantages of each

Chapter 5: The Many Flavors of Loans

If you can imagine it, it's probably available. There are literally thousands of loan schemes out there. But here's a rundown on the main mortgage types – most good in the right circumstances and some questionable under any circumstances. We tell you more about many of these plans on other parts of our website, but here's a handy summary...

Adjustable Rate Mortgage (ARM)

Also known as hybrid or FIRM (Fixed Interim Rate Mortgage), an Adjustable Rate Mortgage is generally a 30-year mortgage where the starting rate and payment are fixed for a number of years. After that period, it converts to a 1-Year ARM (adjustable rate mortgage whose rate can change annually) for the rest of the loan term.

The most common fixed-rate periods is 5 years, but 7 and 10 years are available. These are also known as 5/1, 7/1, and 10/1 mortgages respectively. Generally, the shorter the fixed period, the lower the starting rate. These starting rates are almost always below 30-Year Fixed-Rate Mortgages and above 1-Year ARMs.

This type of mortgage is often the best value for most homeowners, but is not what most people take. Most people choose 30-year fixed-rate mortgages because the rate and payment don't change. And you pay a higher rate for that benefit. But on average, most people stay in their home 5 to 7 years. Why then would you pay thousands of dollars in extra interest to fix the rate for 30 years?

In the example below, a 5/1 Adjustable Rate Mortgage saves you $9,336 over the first five years. You still save over $5,585 after 10 years if rates steadily rise.

This chart compares the interest you will pay through 5, 7, and 10 years on a $150,000 mortgage with no points if you get a 30-year fixed rate, a 5/1 adjustable, or 1-year adjustable rate loan.

Assumptions: starting rates are 5.875% for 30-year fixed, 4.625% for 5/1 adjustable rate mortgage (ARM), 3.250% for 1-year ARM. The 1-year ARM rises 1/2% each year. The 5/1 goes to 5.75% in year 6 and rises 1/2% each year thereafter.

You should also evaluate the caps on any Adjustable Rate Mortgage you're considering. Caps are the maximum amount a rate can change. There are three caps on most Adjustable Rate Mortgages. They are:

  1. Initial change – This is the maximum amount the rate can change up or down at the end of the fixed-rate period. The longer the fixed-rate period, the higher the initial cap is likely to be.

  2. Annual change – This is the maximum amount the rate can change up or down at each annual adjustment except for the first adjustment if different. For example, say the annual change cap is 2% and the index rate moves from 5% to 7.5%. Your rate would go no higher than 7% for this change.

  3. Lifetime change – This is the maximum amount the rate can change up or down for the life of the loan. For example, if you opened a mortgage at 7% with a 5% lifetime cap. The lowest the rate could go is 2% and the highest it could go is 12% at anytime during the loan. For most loans, annual caps would keep you from going there all at once.

Choosing the fixed-rate term of an Adjustable Rate Mortgage is largely a trade-off between monthly payment and how long you need the fixed-period to last. Ask yourself:

  • How long do you expect to have your home or your mortgage? – Most people move or refinance their mortgages every five to seven years. If you plan to go longer, you might want to pay a little more each month to fix the rate for a longer period.

  • Is having a lower payment now more important? – You may need a smaller payment to be able to buy your home. If you fix the rate for a shorter period, you'll start out with smaller payments. If you don't expect to move or refinance until after the first rate adjustment, ask what the maximum monthly payment could be at the first adjustment. If you think you will be able to afford it by that time, going for the smaller payment could be the best decision.

The 5/5 Adjustable Rate Variation

A more recent innovation is the 5/5 Adjustable Rate Mortgage. Just like the 5/1, the initial rate is fixed for the first five years. Unlike the 5/1, the rate adjusts up or down once every five years. That's a total of five adjustments over a 30-year term instead of 24 potential adjustments for a 5/1. The 5/5 has change and lifetime caps like other adjustable rate loans.

A 5/5 gives you more stability in your rate and payment than a 5/1, but at a lower interest rate than a 30-year fixed. You'll only have one change over the first ten years. It's like refinancing to market rates every five years without the extra costs.

Fixed-Rate Mortgages

The interest rate and monthly payment remain the same for the life of the loan. Fixed-Rate Mortgages are the most popular type of loan – especially the 30-year Fixed-Rate. Why? It's easier to budget when you know your mortgage payment won't change. And if your annual salary rises gradually over time, your mortgage payment will gradually become a smaller percentage of your take-home pay.

Generally, the rate will be lower if you shorten the term of the loan. Rates for 20 year terms are lower than 30 and 15 is the same or less than 20. Loans fixed for 40 years will have rates equal to or higher than 30-year loans. For the same loan amount, though, the shorter the term, the higher the monthly payment. That's because you're paying off the loan principal faster. The total interest you pay over the life of the loan drops the faster you pay off your mortgage. Fixed-Rate Mortgages generally cost more during the first years of a mortgage than Adjustable Rate Mortgages.

Adjustable Rate Mortgages (cont.)

Also called ARMs. ARMs can be good for you, because they allow you to benefit when rates go down, however, ARMs can also be bad for you, because they force you to pay more when rates go up. But, generally speaking, an ARM is worth considering. ARMs are a good choice for most people when they plan on selling their home or refinancing within the next five years or if market mortgage rates are high and expected to fall. Over the last twenty years or so, anything 10% or above is considered high.

ARM rates are based on a publicly available index plus a margin. The most common index is the 52-week yield on U.S. Treasury Bills. The margin is added to the index to arrive at the fully-indexed rate. A common margin is 2.75%. So if the 52-week T-Bill Yield was 5.00%, the fully-indexed rate would be 7.75%.

ARMs can vary in how often the rate can adjust, how much they can go up or down with each adjustment, and how far they can ever go above or below the initial rate. Loans that can adjust once a year are called 1-Year ARMs. In some places, 3-Year and 5-Year ARMs are available. The maximum changes are called caps. The most common cap is a change up or down of no more than 2% per year and 6% over the life of the loan.

Be wary of ARMs that change more frequently than annually or can go up more than 2% in a year. Be wary also of ARMs where rate changes don't also change your payment. Why? If rates go up and your payment doesn't, you'll pay more in interest and less in principal. When you go to sell your home, you'll have less equity to show for the payments you made. These are sometimes called Deferred Interest ARMs or Negative Equity Loans.

ARMs come in many flavors. As we mentioned earlier, some mortgage companies have ARMs that raise the rate quickly when rates go up, but don't lower it quickly when rates go down. You don't want an ARM like that. StreetWise for Homebuying and Mortgages will help you determine if an ARM is right for you, and what type of ARM is best, if it is.

Balloon Mortgage

Watch out! A balloon mortgage gives you a fixed number of payments, but doesn't fully pay off your loan. At the end of the payments, you'll have a huge final payment. If you're very careful, balloon mortgages can be useful in certain circumstances.

For instance, if you know for an absolute fact you're going to sell your home in ten years, a ten year balloon may be a good way to have a lower house payment right now. You can make small payments on your mortgage for those ten years then pay off your loan when you sell the home in ten years. Therefore, the whopping final payment in our example would be paid out of the sale of the home. Sounds very reasonable.

But there are down sides. You'll be paying interest on the balloon amount throughout the term of the mortgage. A more conventional mortgage will pay your principal down faster and save you interest. As a result, you'll own a larger portion of your home's value when you sell. That gives you more to put down on the next home, saving you interest on that one as well.

In the real world, don't choose a balloon without talking with us at length. We won't recommend a mortgage plan that isn't in your best interests.

Bridge Mortgage or Bridge Loan

A mortgage loan that lets you borrow some of the equity in your home until that home sells. People usually use bridge mortgage loans to help them buy a second house before their first house has sold or to finance the construction of a new home. Bridge loans can be very dangerous. What if the first home doesn't sell? Can you afford to support two mortgages? Be careful with these loans.

Convertible ARMs or CARMs

CARMs allow you to convert an ARM, an adjustable rate mortgage, to a fixed mortgage. CARMs can be great if interest rates are high now, but will probably be lower later. These mortgages typically allow you to switch the mortgage to a fixed-rate at current market rates with no or low fees.

You usually can only convert on the first three to five anniversary dates on the loan. The theory is you can switch when rates drop, but you'll always increase your rate by exercising the option. Why? Because the fully-indexed ARM rate at any given moment will be lower than the fixed-rate available to you when you want to convert. This is true because, with an ARM, you are sharing the financial risk of rate increases with the lender. On fixed-rates, the lender takes all the risk that market rates will rise above the rate you got when you opened your loan. This type of mortgage has grown more difficult to find because they don't conform to Freddie Mac/Fannie Mae guidelines.

GEMs or Growing Equity Mortgage

GEMs have a gradually increasing payment, but all the payment increase goes to reduce your loan principal. GEMs allow you to pay mortgages off earlier, save thousands in interest, and build equity faster. For instance, a 30-year GEM mortgage, depending on the interest rate, can usually be paid off in 18 years with a GEM. These are not widely available because they don't conform to Freddie Mac/Fannie Mae guidelines.

Interest-Only Mortgages

The purpose of an interest-only mortgage is to provide you the lowest monthly payment possible. The down side is you are not reducing your loan principal as you go along. During interest-only periods, you only grow equity in your property if its value increases. Since the collapse of the housing bubble, these are generally unavailable.

Biweekly Mortgage

A true biweekly mortgages had a biweekly payment equal to one-half a regular monthly payment for that term. This reduced payment is then made biweekly. Essentially, you are making the equivalent of a 13th monthly payment each year. Unfortunately, market pricing for these loans in recent years has been at higher rates than 30-year conforming loans. It's often a better deal to get a 30-year conventional loan and make extra principal payments each year.

Important StreetWise Tips...

  • If you're thinking about touring model homes, be wary of the “fast close.” Many states are chock full of wonderful new housing developments and subdivisions, and very few things in the housing field are as much fun as visiting them. But be careful of developments that put you through a “fast track” sales system just like the “fast track” sales system at automobile dealerships.

    • Fast track systems, whether at a dealership or in the comfort of a beautiful model home, are good for the seller's pocketbook – not your pocketbook. Some homebuilders and subdivisions, for instance, literally won't let you tour a model home without going through the builder's sales office!

    • Some try to push you into signing a “Builders Contract” the first time you visit a model home. In many states, Builders Contracts are not standardized. For “just a few hundred dollars” these contracts legally bind you to buy a home and use the builder's mortgage company and agents.

    • Many “Fast Track” builders and subdivisions promise you “upgrades” if you sign with them on the spot. What should you do if this happens? Forget the upgrades! Don't ever enter into a relationship with a mortgage company or subdivision representative without comparing costs and services. We help you do that.

    • If you're really in love with a home in a new subdivision, tour the house, but don't be lulled into signing anything on the spot.

  • Be cautious of buying HUD foreclosure properties without doing your homework. These properties are virtually always sold “as is,” a very expensive phrase in the real estate world. If you find a HUD property that really suits your needs, we can help you with all the legal technicalities.

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