Fixed Rate Loans
Fixed rate loans are loans that carry a fixed monthly principal and interest payment every month for the term of the loan. So if you were to get a 30 year fixed loan and your principal and interest payment is $700 you can expect that it will be $700 for the entire 30 years. The only consideration with this is your taxes and insurance. If you have chosen to escrow (include your taxes and insurance) in your monthly payment, every month you may see a variance in your payment but it will not be because your interest rate has changed. If your taxes and insurance go up or down you will see a difference in your payment. However, it will not be because of a change in your interest rate. For example, if you have a $700 principal and interest payment, your taxes are $1200/year, and your insurance is $500/year then your total payment will be $841.67 principal, interest, taxes and insurance(PITI) every month. Let’s assume that you taxes go up a year from the date you obtained your mortgage to $1300/year. You new payment will be $849.70 PITI per month. Some people would assume that their interest rate changed when in fact there was an adjustment to the payment for the increased taxes.
Fixed rate loans have it variances as well. You can choose to have a fixed rate loan over 30 years, 25 years, 20 years, 15 years, and even 10 years. The term that you choose to take really depends upon how much you can afford to pay each month. The lower the term the more the monthly principal and interest payment will be. For example, if you have a $100,000 mortgage at a rate of 6.50% fixed over 30 years, you payment will be $632.07. If you choose to select the term of 20 years your payment will be higher at $745.57 a month.
Another thing to consider is the amount of interest you pay based on the length of term you choose. Using the illustration above, if you were to select the 30 year payment you would ultimately end up paying over $127,000 in interest for the life of the loan. If you selected the 20 year payment you would end up paying over $78,000 in interest over the life of the loan. This is a $49,000 difference in interest. I can show you how to achieve the 20 year results with a 30 year term in another article but it is doable.
All and all fixed rate loans are for those who are less risky and want the stability of knowing that there principal and interest payment will not change throughout the life of the loan.
Adjustable Rate Mortgages (ARMs)
Adjustable Rate Mortgages (ARMs) are quite a bit different than fixed rate mortgages. They come in many varieties. When you choose to take an ARM there are outside variables to consider that make these types of loans more risky.
Let’s start by explaining what an ARM is. An ARM is a loan that that has a fixed rate for a predefined period of time that will adjust after that timeframe has passed. For instance, you might have a 2 year ARM. This means that you rate will be fixed for 2 years and after that it will begin to adjust according to the terms defined in your mortgage note.
You might be thinking, how I know how much my rate will change. Well the short answer to that question depends upon the type of ARM you have. There are many types of ARMs available. ARM loans usually come with 3 major characteristics. You have the margin, index, and the term. There are other variables to consider but I will only deal with these 3 in this article. The margin is the percentage that will be added to the index to determine your new interest rate. The margin is predefined by the lender at the time you take out your mortgage. The mostly commonly used indexes are the London Interbank Offered Rates (Libor) and Cost of Funds Index (COFI) indexes. Indexes are public information and can be found on many financial websites. The one I use most often is http://mortgage-x.com. Here you can find historical information on the index that you are interested in to help you make an informed decision on selecting an ARM loan. The term for an ARM loan has 2 parts. The first is the amortization term. How long are you taking this loan out for? Is it 10 years, 20 years, or 30 years for example. The second part is the length of time that you ARM will be fixed. Is it 6 months, 1 year, 2 years, 3 years, 5 years, or even 10 years?
Now let’s pull it all together by using an example. You select a ARM loan that is has a 30 year amortization, the rate is fixed for 2 years, your margin is 2.00%, the index is a 6-month Libor, and you took this mortgage out in December of 20015 when the 6-month Libor index was 2.7751%. Let’s also assume that your start rate was 5.00%. Now that your 2 years are up it is time for your rate to adjust. Here’s how that works. You would go to a site like the one I listed above and find out what the 6-month Libor index is for this month which is 5.37%. You would then add the current index to your margin that the lender gave you when you took out the loan which was 2.00%. That would mean that your new rate would be 7.37%. Now in many cases there is what we call a “cap” on how much a rate can increase at adjustment time. Generally for the first adjustment the cap is 2.00%. So in this case your new rate would be 7.00%. Quite a bit of increase isn’t it.
All and all ARMs are good for those people who don’t mind taking a risk for the sake of having a lower start rate. The initial fixed rate period you choose should be in line with the length of time you plan on being in your home or the length of time you plan to refinance so that you are not affected by the increase in rate. ARMs loans has its advantages and disadvantages and should only be used by the financially savvy.