Mortgage Basics

When buying a home it is important to learn about the variety of mortgage options and to determine which mortgage type is the best for your situation.  If you qualify for more than one option you would save yourself money in the long run.  Your local banker or a mortgage broker are excellent resources for locating the best mortgage at the best rates.

Mortgages fall into four major categories:

  • Government Loans such as VA and FHA,
  • Fixed-Rate Mortgages,
  • Adjustable-Rate Mortgages, and
  • Convertible ARM

Government Loans

FHA Loans:  The Federal Housing Association offers loans to lower-income Americans.  Watch for the FHA approved when looking for homes.

VA Loans:  Veterans may qualify for a loan from the Veterans Administration.  VA loans have excellent interest rates but there is a limit on the amount you can borrow.  This option is used mostly by first time home buyers.

Fixed-Rate Mortgages

Fixed-Rate Mortgages are the most common.  If you want a payment you can count on for a long of a period of time, a fixed rate mortgage works best.  With a fixed rate you will have the same payment for the rest of your life.  Fixed-Rate Mortgages are very popular when interest rates are very low.  Even though the payment is a set amount you can make extra payments to the principal of the loan and pay off the loan sooner.  This would save a considerable amount of interest over the life of the loan.

A Fixed-Rate Mortgage works well for people who plan to stay in the home for many years and want to know what their payment will be each month.  Fixed rate mortgages are offered in varying lengths and normally range from 15 to 30 year paybacks.  Thirty years is the most common choice for first time homebuyers as the payments are the lowest and the mortgage is the easiest to qualify for.  Most of the payment in the early years of the mortgage are tax deductible as interest expense.

Adjustable-Rate Mortgages (ARMs)

ARM rate rises and falls depending on the prevailing interest rate.  The interest rate is usually lower than a Fixed-Rate and therefore the payment is lower.  The lower initial payments will allow you to qualify for a larger loan than if you chose a fixed-rate type.  The downside is that your payments can increase if/when the rates go up.

ARM interest rates are tied to a specific financial index (such as Certificate of Deposit index, Treasury or T-Bill rate, Cost of Funds-Indexed Arms or COFi, or LIBOR [London Interbank Offered Rate]) and your payment will be based on the index your lender uses plus a margin (generally two to three points).

Fortunately, the amount an ARM can raise is not unlimited.  There are “caps” on how much your lender can increase your rate, both for a period of one year and for the life of the loan.  When interest rates are very high adjustable rate mortgages are very popular.  They are also recommended when your planned ownership of the property is short-term or if you expect your income will increase to cover any potential rise in the interest rate.

In the long term if interest rates rise the rate as it is adjusted could result in a higher effective rate than the Fixed-Rate Mortgage interest rate available at the time of purchase.  Get the formula used by your lender in writing and make sure you understand what it means.

Convertible ARMs

The Convertible ARM combines the initial advantage of an ARM of lower payments and converts to a stated fixed rate after a predetermined number of years.  This option is desirable when interest rates are low and the future rate is not guaranteed.  In the beginning the Coverable ARM acts like an ARM and once the ARM is converted the loan becomes a fixed rate mortgage with stable payments for the rest of the life of the loan.

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