Financing Strategies - Mortgage Financing
1. Conventional vs. adjustable rate mortgage
- Conventional or fixed-rate mortgage - Loan rate does not fluctuate with interest rate changes. Tends to feature higher rates than adjustable-rate mortgages. 30- and 15-year terms most common.
- Adjustable-rate mortgage (ARM)
- Allows adjustments of the loan interest rate at pre-specified regular intervals. Also known as a "variable-rate mortgage" or a "floating-rate mortgage".
- Components of an adjustable-rate mortgage:
- Initial rate - the initial rate charged on an ARM for a specified period, anywhere from three months to 10 years. The shorter the period, the lower the initial rate.
- Interest rate index - An index used to calculate rate on ARMs that is independent of the lender. As the index falls or rises, the ARM does the same. Some common indexes include the rates for 6- or 12-month U.S. Treasury securities or the Prime Rate.
- Margin - The number of percentage points added to an index rate to determine the current ARM rate.
|ARM rate = index rate + margin|
For example, if the index rate is 5% and the margin is 2%, then the ARM rate is 7%.
- Adjustment interval - How often the ARM rate will be reset. One-year adjustment interval is most common.
- Rate cap - Limits how much an ARM rate can change. Periodic cap limits how much a rate can change at a given adjustment interval. Lifetime cap limits the total rate adjustment during the life of a loan.
- Payment cap - Sets a dollar limit on how much a monthly payment can increase. This limits the change in monthly mortgage payment, but it does not limit the interest rate being charged. When rates are rising, less of payment goes toward principal and more toward interest.
- Negative amortization - A situation in which monthly payments are not enough to cover interest due on the loan. Unpaid interest then is added to loan balance, meaning borrower's balance grows each month rather than decline.