Mortgages Explained (Part 1 of 2)

With foreclosures at their highest, lenders are going back to more traditional home mortgages. This month we will outline the various types of loans available and explain why some may be a better option for you than others.

by Corrie Reed

When Mom and Dad took out a home loan, there were very few choices. They most likely had a 20 percent down payment and took out a 30 year, fixed rate mortgage. Today, there are a wide range of home mortgage choices, but they can be divided into two basic types: Fixed rate mortgages and adjustable rate mortgages.

Fixed rate mortgages (FRMs) were the only type of mortgages that were available decades ago and, as the name implies, the interest rate stays constant for the life of the loan. Fixed rate mortgages are still popular because of their predictability. No matter what happens with interest rates, your mortgage payment stays the same. The most common terms of a fixed rate mortgage are 30, 25, 20, or 15 years. Fixed rate mortgages are ideal for people who want to know what their payments will be every month. If interest rates rise, the monthly payments remain the same. If interest rates fall below your rate though, you may consider refinancing to lock in the loan at the lower rate.

Adjustable rate mortgages (ARMs) are the opposite of a fixed rate mortgage. The interest rate fluctuates in a adjustable rate mortgage and causes your monthly payment to change during the life of the loan. Based on the specific terms of the loan, the interest rate could change from month to month (a fully-adjustable loan) or a period of every six to twelve months. Generally, your monthly payments will increase as interest rates go up; and your payments will decrease as interest rates go down.

Adjustable rate mortgages became popular when interest rates were very high (as much as 18%). Few people could afford to finance a home at such a rate and lenders began offering lower initial rates that more home buyers could afford. Anyone considering this type of loan needs to be aware that the rate will increase and so will the monthly payment. You must look closely at the terms of the particular loan to be sure that it's a good choice for you.

*Common terms offered by lenders are explained in the right column.

Five of the most common home loans are as follows:

(1) Hybrid loans are a cross between a fixed and an adjustable rate mortgage and are the most popular type of mortgage today. Hybrid loans stay at a fixed rate for a predetermined amount of time (one to ten years) and then convert to an ARM (usually at the prevailing interest rate). Hybrid loans are a good choice if you will be selling your home before the rate is scheduled to increase or if you will be able to refinance the loan at a good, fixed rate.

(2) A balloon mortgage starts out at a fixed rate for a set amount of time (typically four to ten years). Unlike a hybrid loan that converts to an ARM, a balloon mortgage requires that the balance (the "balloon") be paid in full at the end of the term. Only consider this type of loan if you are desperate to purchase a property and it is the only option you can afford. You must be sure however, that you will be able to refinance before the balloon comes due or have the cash on hand to pay off the balance.

(3) In an interest-only loan, your monthly payment is applied only to interest of the loan. Interest rates are generally higher with this type of loan, but the payments are still lower than with fixed rate loans because nothing is going toward the principal initially. At some point, the lender will usually increase the amount of the monthly payments to ensure that the loan is paid out in the remaining time of the loan. If the borrower has a 30-year loan for example, he may make interest-only payments for the first ten years of the loan, but then the lender may increase the payments to ensure that the borrower pays the total amount of the loan in the remaining twenty years of the loan. If you are short on cash, an interest-only loan may be a good choice to get you into a home. Look for one that does not have a prepayment penalty so that you can put any extra funds toward the balance of the loan.

(4) Subprime loans are loans for buyers that have less than stellar credit. This type of loan is typically a one-of-a-kind. Because each one is custom, based on the borrower's particular credit history, subprime loans tend to be more expensive. This is the loan for the person that has blemished credit. You will be offered less favorable terms up front (higher interest rates), but as you make regular, on-time payments you may increase your credit score enough to qualify to refinance with better terms and interest rates.

(5) Negative amortization loans (deferred interest loans) are an ARM, but in this type of loan the rate and payment don't change at the same amount of time. So, it's possible for the interest rate to go up and your monthly payment to remain the same. When this happens, the payment may not adequately cover the interest and principal of the loan, causing interest to accrue. If home values in your area are rapidly increasing, you will offset the accruing interest because you are building equity in your home through appreciation. But if home values fall, you may end up owing more than your home is actually worth. Only choose this type of loan if you can virtually ensure that your finances will get better in the future, enabling you to afford the higher payments of a standard loan or that the property's value will increase significantly. Be aware that many people have found themselves on the losing end of this type of loan- stuck in a home that they cannot afford and unable to sell it for the amount that they owe on the loan.

Mortgage Brokers
Since the types of loans have become more complex in the last couple of decades, fewer home buyers are working directly with banks or other lending institutions. Instead, up to 80% of home owners now use a mortgage broker to help facilitate their home loans.

It's a mortgage broker's job to find the best mortgage for you and your individual circumstances. A broker has relationships with a range of lenders that offer different types of loans and will give advice on which one is the best for you. Having a mortgage can be especially in establishing a loan if you have a lower credit rating or other special circumstances.

A services offered by a mortgage broker will depend on the depth of their service and liabilities, but they typically offer the following services:

Assessment of the borrowers circumstances (Mortgage fact find forms interview). This may include assessment of credit history (normally obtained via a credit report) and affordability (verified by income documentation).
Assessing the market to find a mortgage product that fits the clients needs. (Mortgage presentation/recommendations)
Applying for a lenders agreement in principle (pre-approval)
Gathering all needed documents (pay stubs/pay slips, bank statements, etc.),
Completing a lender application form.
Explaining the legal disclosures.
Submitting all material to the lender.

Consider a broker's yield spread before making your final decision about a loan. The "yield" is the fee a broker will receive for having sent a buyer to the company providing the mortgage- you're interest rate reflects the spread.

FYI
Brokers are regulated by federal laws, regulations, and licensing boards to ensure that consumers are educated on the terms and conditions of the various types of loans they offer. And while most brokers are honest, some have been convicted for predatory lending practices in recent years.

Common "Terms" for ARMs
Adjustable rate loans come in many configurations, but they are generally offered in 1, 3, 5, 7, and 10 year terms- the length of time that the interest rate will stay at the initial, set amount. A 1-year ARM will have a set rate for one year, a 3-year ARM will have a set rate for three years, and so on.

Your particular type of loan outlines what happens after the initial rate expires. The initial rate may be fixed for three years and reset for another three years (a 3/3 ARM) or the initial rate may be fixed for five years and reset for another three years (a 5/3 ARM)- these are just two possible examples out of numerous ones available.

There are certain parameters that are preset in the loan, adjustment caps and life-of-loan caps, that restrict the amount that the interest rate can rise and fall. A 3/1 ARM may have an annual adjustment cap of one percent and a five percent life-of-loan cap. Let's say that if your initial rate is five percent. Your annual rate will increase as much as one percent each year so that you will know your rate will be no more than six percent the next year, no more than seven the next, and so on. The five percent life-of-loan cap means that over the life of the loan, the rate can go no higher than ten percent.

TIP: In order to not feel the pinch of increased interest, make a higher monthly payment while your interest rates are lower. Since the interest rate is calculated based on the total amount you owe, lowering that amount will help you to keep your future payments in check. For example, let's say you borrow $100,000 and the monthly payment is $500; you make a monthly payment of $600 instead. At the end of the year, you have increased your equity by $1200. When your interest rate resets, it will be calculated on the lower balance. Do make sure that your particular loan does not have a prepayment penalty.

FYI
Several days after you submit your formal loan application, you will receive a good faith estimate. It will disclose to you all the fees associate with the purchase, any required impounds for escrow of taxes, insurance, or mortgage insurance. Check over it thoroughly and ensure that it meets the parameters you established with the financial institution or mortgage broker.

Resources
Federal National Mortgage Association/ Fannie Mae
A share-holder-owned company that works with lenders to offer loans specifically for low, moderate, and middle income individuals.

Federal Housing Authority/ FHA
Insures home mortgages (FHA loans) allowing lenders to work with borrowers that have less-than-perfect credit.

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