MORTGAGE OPTIONS

Understanding Your Mortgage Options

Once you think through your goals and determine how much you can comfortably afford to pay each month, then it’s time to choose a mortgage. With so many different mortgages available, choosing one may seem overwhelming. The good news is that when you work with a responsible lender who can clearly explain your options, you can better select a mortgage that is right your financial situation.
Here are the major mortgage types:

Fixed-rate mortgages

With a fixed rate mortgage your interest rate and monthly payment remain the same for the life of the  loan. This type of mortgage tends to be the most popular because it protects homeowners from the possibility of future monthly payment increases and is very straightforward.
Advantages

  • Stability. You know exactly what you will be paying toward principal and interest every month for the entire length of the loan.
  • If interest rates go up, you are protected. Your rate (and your principal and interest payment) will stay the same.

Consideration

  • If interest rates go down, your rate (and principal and interest payment) will stay the same.
  • When might a fixed-rate mortgage make sense?
  • If you plan on owning your home for a long time (usually 7 years or more).
  • If you have a monthly budget you need to stick to and prefer payment stability. (Keep in mind that your property taxes and homeowners insurance can increase.)
  • These payments can fluctuate throughout the life of your loan. But your monthly principal and interest payment will never change.)

Fixed-Period Adjustable-Rate Mortgage (ARM) or hybrid ARM

Most lenders today offer a fixed-period or “hybrid” ARM,—which is an adjustable-rate mortgage that features an initial fixed interest rate period, typically of 3, 5, 7, or 10 years. After the fixed-rate period expires, the interest rate becomes adjustable for the remainder of the loan term. Fixed-period ARMs are often named by the length of time the interest rate remains fixed.
Example: In a 5/1 ARM, the “5” stands for the five-year “introductory period,” during which the interest rate remains fixed. The “1” shows that the interest rate is subject to adjustment once per year after the introductory period and for the remainder of the loan term.
About the introductory period: The rate on this kind of loan tends to be lower during the introductory period, which could mean a lower starting monthly payment. However, when the introductory period ends, your rate will go up or down depending on changes in the financial index to which your loan is associated. If considering an ARM, carefully consider your ability to handle potential increases to your rate, and consequently, your monthly principal and interest payment.
Caps: ARMs have two kinds of rate caps. The rate can go up or down in any single adjustment period, limiting how much your loan payment can change when it adjusts. Life Time Caps establish a maximum, and minimum, interest rate over the entire life of a loan. Many caps allow a significant increase in each adjustment period and over the life of the loan, so despite having a cap, the increase in the monthly payment allowable under the cap may still result in “payment shock.” Such an increase may make it difficult, or impossible, for you to pay your mortgage on time if interest rates rise. If you’re considering an ARM, find out what the caps would be and then run the numbers to see if you could still comfortably afford the monthly payments allowable under the rate caps.
Advantage

  • Hybrid ARMs generally offer lower rates during the introductory fixed rate period than fixed-rate mortgages.

Considerations

  • After the introductory period’s fixed rate expires, the rate is subject to adjustment. The rate could increase at this point, which would also increase your payments. This can make paying your mortgage on time more difficult.
  • If you choose this kind of loan, be sure it includes an adjustment cap and/or lifetime interest cap. Keep in mind that many adjustment or lifetime caps would still result in payment shock, which is a term used to describe a significant increase in your monthly payment. For example, if you had a 5/1 ARM with a starting interest rate of 4.0% (and interest rates rose) and your rate increased by 2 percentage points in the first two adjustment periods, by year 7, your interest rate would be 8.0% — so your monthly payment would double from the starting monthly payment. So ask for details and plan accordingly.

When might a Hybrid ARM make sense?

  • If you believe interest rates will go down in the future; however, because rates are currently low, it may be more likely that rates will increase. So it’s important that you are confident that you can afford the monthly payment if the interest rate adjusts upwards to the maximum amount possible with this mortgage.
  • If you plan to sell the home before the introductory period ends. Of course, there is an element of risk in this plan, as it can be difficult to predict exactly how long it will take for a home to sell.

 

Interest-Only Mortgage (I/O)

Interest-only mortgages are adjustable-rate or fixed-rate loans, which contain interest only payments option during a set period in the first years of the loan, often the first 10 years. During the interest-only period, borrowers can delay making principal payments and make monthly payments that only repay interest. After the interest-only period ends, assuming that a borrower selected this option and made only interest payments, the monthly payments would significantly increase when the required monthly payments started to include principal plus interest.
If there were no principal payments made during the interest-only payment period, the unpaid loan principal wouldn’t be reduced. That principal would now need to be paid back in the remaining years of the loan, in addition to the interest due on the total balance of the loan. So the payment shock would be quite significant when the interest-only period ends.
In general, interest-only mortgages may be a good choice for only a small number of buyers with very special circumstances. Carefully consider payment shock when considering an interest-only payment option.
Advantages

  • This type of mortgage may be a fit for a small sub-set of buyers with fluctuating incomes, as long as they are disciplined enough to pay more than the minimum as often as they can and/or plan to pay larger amounts in the future.

Considerations

  • Because your monthly payment would only repay the interest accruing on this mortgage, the only equity you would have in your home would be the amount you paid as a down payment. You would not build equity unless the market value of your home were to go up. And if the market value of your home were to decline, then you could lose part or all of your down payment.
  • This kind of mortgage can be difficult to get because it is more of a risk for lenders.
  • It’s critical to know the highest possible monthly payment you may have to make on this loan, and to be confident you could pay it, potentially for an extended period of time.

When could an I/O mortgage make sense?

  • If you’re opting for lower starting payments to invest money into home renovations or remodeling, because you believe that these would significantly increase the home’s value and you could refinance or sell in the future.
  • If you know you’ll be moving before the interest-only payment term expires, and you don’t need to access the equity (your down payment contribution) from the home in order to buy a new one.
  • If the bulk of your income is paid in bonuses or commissions, and you want to make small monthly payments and use large income distributions to periodically pay down principal.
  • If you expect significant income increases in the short term, like a spouse going back to work.

Alternative mortgage options

Some eligible homebuyers may qualify for an
FHA Mortgage (Federal Housing Administration) or a
VA Mortgage (Department of Veterans Affairs) loan. These loans tend to allow a lower down payment and
credit score when compared to conventional loans.
FHA loans: FHA loans are government-insured loans that could be a good fit for homebuyers with limited income and funds for a down payment., a FHA-approved lender, offers these loans, which are insured by the Federal Housing Administration (FHA)
Advantages

  • This kind of loan is helpful for applicants who don’t have a 20% down payment saved.
  • These loans can also help applicants who need more flexible income or credit requirements. Be aware that minimum credit scores apply so not all applicants will qualify.

Considerations

  • There’s a maximum loan amount, which can vary depending on where the home is located.
  • FHA loan programs typically require you to pay both an upfront mortgage insurance premium (UFMIP) and a monthly mortgage insurance premium (MIP). You’ll need to factor these premiums in when you set your budget.
  • There tends to be a more complex approval process for an FHA loan, and often times more paperwork to fill out.
  • An FHA Loan may help get you into a home, but it’s important to be sure the total monthly payment that comes along with the loan is one you can comfortably afford.

VA loans: VA loans are offered by VA-approved lenders are insured by the Department of Veterans Affairs To qualify for a VA Loan, you must be a current or former member of the U.S. armed forces or the current or surviving spouse of one. If you meet these requirements, a VA loan could help you get a mortgage.
Advantages

  • VA loans can help reduce your down payment requirement, sometimes to zero.
  • These loans may also help you get a lower interest rate on your loan.

Considerations

  • There are limits on the available loan amount.
  • Although a VA loan can have low down payment requirements or interest rates, the borrower is still responsible for making the payments. So it is equally as important with this type of loan as any other to be sure the total monthly payment is one you can comfortably afford.

FHA Loans: FHA mortgage insurance protects the lender if a borrower defaults on the FHA loan. Each FHA borrower pays a mortgage insurance premium. The premiums are collected and used by the FHA to reimburse the lender (not the borrower) should the borrower default and the lender must foreclose upon the loan/sustain a loss. This insurance enables a lender to provide loan options and benefits often not available through conventional financing.
VA Loans: The VA guaranty helps to protect the lender (not the borrower) against loss if the borrower fails to repay the VA loan. Borrowers pay an upfront funding fee towards the VA guaranty. This guaranty enables a lender to provide loan options and benefits to military veterans and other qualified participants that may otherwise be unavailable through conventional financing.
Maximum loan amount varies by county. VA loans require a VA funding fee at closing. The fee is higher with a zero down payment. If a down payment of 5% or more is made, the fee is reduced. The VA funding fee is non-refundable.
Down payment assistance and/or bond programs may not be available in your area. Down payment assistance amount may be due upon sale, refinance, transfer, repayment of the loan, or if the senior mortgage is assumed during the term of the loan. Some programs require repayment with interest and borrowers should become fully informed prior to closing. Not all applicants will qualify. Minimum credit scores may apply. Sales price restrictions along with income and/or census tract requirements may apply. Homebuyer education may be required. Owner-occupied properties only. Maximum loan amounts may apply.

Glossary

Principal is the amount of money borrowed on a loan.

Lender is an individual or business entity making a loan.

Interest is a fee charged for borrowing money. Also refers to money that a financial institution may pay individuals for keeping their money in an account there (such as an interest-bearing savings account).

Payment shock is a significant rise in a homeowner’s monthly home payment, usually as the result of rising interest rates (in the case of an adjustable-rate loan) or the end of an interest-only introductory period.

Closing costs are Fees paid at or prior to the closing of your loan. They may include attorneys’ fees, as well as fees for preparing and filing a mortgage, and for taxes, title search, and insurance. They include the expenses incurred in obtaining the loan and in transferring the ownership of any collateral property from the seller to the buyer. Generally, closing costs are typically about 3% of the total loan amount. Also called settlement costs.

Term is the number of years it will take to pay off a loan. The loan term is used to determine the payment amount, repayment schedule and total interest paid over the life of the loan.

Adjustment cap is a  limit to how much a variable interest rate can go up or down in a single adjustment period.

Interest rate is the Cost for the use of a loan, usually expressed as a percentage of the loan, paid over a specific period of time. The interest rate does not include fees charged for the loan. See also: annual percentage rate (APR).

Rate cap is a limit on how much the interest rate can change, either per adjustment period or over the term of the loan.

Fixed-rate mortgage is a home loan with a predetermined fixed interest rate for the entire term of the loan.

Property tax is the fixed percentage based on the appraised value of your home that you pay to the county in which the home is located. The specific percent varies dramatically from county to county in every part of the country. You pay this tax annually, semiannually or as part of your monthly mortgage payments. Depending on when you actually close your loan, some of this property tax may be due at the time of closing. The local county assessor’s office can give you the rate for your county.

Homeowners insurance is the Insurance to protect your home against damage from fire, hurricanes and other catastrophes. Usually, hazard insurance also covers you against theft and vandalism, as well as personal liability in case someone is hurt or injured on your property. A lender will likely require you to name it as a payee under the insurance if you need to make a claim. Also called Hazard Insurance.

Credit Score is a number that rates the quality of an individual’s credit. Credit reporting agencies calculate this number, often with the assistance of computer systems, as part of the process of assigning rates and terms to the loans they make. The number helps predict the relative likelihood that a person will repay a credit obligation, such as a mortgage loan. In general, the higher your credit score, the more likely you are to be approved for and to pay a lower interest rate on a loan.

FHA home loan is a mortgage home loan that is insured by the Federal Housing Administration (FHA). Also known as a government loan. FHA mortgage insurance protects the lender (not the borrower) if a borrower defaults on the FHA loan. This insurance enables a lender to provide loan options and benefits often not available through conventional financing.

Down payment  is the amount of cash you pay toward the purchase of your home to make up the difference between the purchase price and your mortgage loan. Down payments often range between 5% and 20% of the sales price depending on many factors, including your loan, your lender, your credit history, and so forth.

Lifetime adjustment cap  is a limit on how much the variable interest rate can increase during the term of a loan.

Adjustable-rate mortgage (ARM) is a mortgage or home equity loan in which your interest rate and monthly payments may change periodically during the life of the loan, based on the fluctuation of an index. Lenders may charge a lower interest rate for the initial period of the loan. Most ARMs have a rate cap that limits the amount the interest rate can change, both in an adjustment period, and over the life of the loan. Also called a variable-rate mortgage.

Refinance is Paying off your existing loan with the proceeds from a new loan, generally using the same property as collateral, in order to take advantage of lower monthly payments, lower interest rates, or save on financing costs.

Equity is the difference between the fair market value (appraised value) of your home and your outstanding mortgage balances and other liens.

Budget is a detailed plan of income and expenses expected over a certain period of time. A budget can provide guidelines for managing future investments and expenses.

Commission is the fee charged by a broker or agent for negotiating a real estate or loan transaction. A broker commission is generally a percentage of the price of the property or loan.

Index is the basis used in a mortgage note or credit agreement, a financial index is the measurement used to decide how much the annual percentage rate will change at the beginning of each adjustment period. Generally, the index plus or minus margin equals the new rate that will be charged, subject to any caps. Lenders use various financial index rates: London Interbank Offered Rate [(LIBOR and Treasury-Indexed ARMs (T-Bills)]

Interest-only payments is when a lender permits you to pay only the interest due on a loan for a portion of the loan term, which lowers your periodic payment during that period, but does not decrease your principal balance on the loan. Making interest-only payments will result in larger payments being due (“payment shock”) at the end of the interest-only payment period. See also: balloon loan and balloon payment.

VA loan is a mortgage that is guaranteed by the Department of Veterans Affairs (VA) for qualified veterans of U.S. military forces. Also known as a government loan.

Mortgage is a legal document giving a lender a lien on real estate to secure repayment of a loan. Mortgage loans generally run from 10 to 30 years, after which the loan is required to be paid off. Also called deed of trust and/or security deed.

Credit is an arrangement in which a borrower receives something of value in exchange for a promise to repay the lender at a later date.