The majority of mortgage loans fall under one of two categories, fixed rate or adjustable rate mortgages. No matter which type of loan you desire, they all are going to revolve around the interest rate and length of the loan. Your credit score is the key factor in determining the interest rate just as with any mortgage or loan.
Fixed Rate Mortgage
Fixed rate mortgages are the most common loan type. With a fixed rate mortgage, you lock-in an interest rate when you apply for your loan. This becomes the interest rate that is charged throughout the length of your mortgage, usually fifteen, twenty or thirty years. Your mortgage payment covers a portion of the interest and a small portion of the principal.
- Interest: Interest is the percentage the financial institution charges you to borrow their money. If you borrow $200,000 and $900 of your monthly payment goes towards interest, by the end of one year, you will have paid $10,800 in interest charges.
- Principal: Principal is the amount that goes towards decreasing your loan amount. If you borrow $200,000 and $200 of your payment goes towards principal, by the end of one year, your original loan amount will be reduced by $2,400.
For the first years of your mortgage, the payment covers a huge portion of interest and very little principal. For example, if your monthly payment is $1100 a month, in the first few years of your loan close to $900 of your mortgage payment will cover interest; the remaining $200 goes towards principal. As time progresses, this will change. Your interest payment will reduce and the amount of principal increases.
Fixed rate mortgages are considered advantageous because they protect homeowners against soaring interest increases. The recent collapse of the mortgage industry is directly related to skyrocketing interest rates. Homeowners couldn't afford their mortgage or home equity loan payments that suddenly doubled or tripled. Those who apply for fixed rate mortgages are protected from increases. The payment amount never changes.
Adjustable Rate Mortgages
Adjustable rate mortgages are extremely appealing to first time borrowers. Banks and other financial institutions offer a low interest rate and then the rate rises over time. If you are purchasing a home for now and plan to move in a year or two, the lower ARM payment makes sense. Now we also recommend you use a service like profam.com for getting life insurance coverage for your ARM Loan. Should you or someone in your family unexpexctedly die, you'll want the piece of mind knowing your mortgage will be paid off in full.
For the first few months, or even years, of an adjustable rate mortgage, the interest rate remains the same. Part of the problem with ARMs is that the buyer becomes used to that low mortgage payment. When the rate changes to match the prime rate plus a certain extra percentage, payments can double or even triple making it hard for homeowners to afford the rise. There are things to remember with adjustable rate mortgages:
- The rate adjusts on a schedule: Some banks will adjust the payment once a month, every quarter or once a year. These terms should be clarified before you sign the papers.
- Pay close attention to the loan margin: A margin is that extra percentage that the bank will charge in addition to the prime rate or whatever index the bank opts to use (treasury, LIBOR, etc.) If the prime rate is six percent and the margin is five percent, your interest rate can go from five percent starting out to eleven percent causing a tremendous jump in your monthly mortgage payment amount.
- Adjustable rate mortgage caps and ceilings: Any adjustable rate mortgage should have a cap and ceilings established. A cap limits the amount that an interest rate can jump in during the adjustment period. Ceilings are set to prevent an interest rate from going higher than a certain percentage during the entire length of the mortgage. Having caps and ceilings in place prevents your payment from becoming too high.
When choosing between a fixed rate and adjustable rate mortgage, you should think carefully. Will your salary increase at the same rate an ARM might increase? Can you afford the fixed rate payment? Are you going to live in that house for a short or long period of time?
