Choosing a Loan
Choosing the right loan requires consumers to review their financial objectives and ask a host of questions, such as:
- How long do I intend to occupy the house?
- What is my tax bracket?
- How much money do I have for a down payment ?
- Is paying the mortgage off early important?
- Can I or should I make extra principal payments?
- Do I want a level payment or a variable payment mortgage?
- Should I finance the closing costs in the interest rate or the loan amount?
- Is my income projected to remain stable?
These questions are important in the loan selection process and a loan officer or other financial advisor can help consumers make informed decisions.
Common Loan Types and General Characteristics
Fixed Rate Fully Amortizing Loans: The most common fixed rate loans are the 15- and 30-year mortgages. In these types of mortgages, the interest rate and monthly payments are fixed for the term of the loan. The payments are calculated so that upon maturity the mortgage loan is paid in full. During the early amortization period, a large percentage of the monthly payment is used for paying the interest. As the loan is paid down, more of the monthly payment is applied to principal. A typical 30-year mortgage takes 22.5 years of level payments to pay half of the original loan amount.
Balloon Loans: Generally, balloon loans have level monthly payments based upon a 30-year fully amortizing schedule, but mature earlier than 30 years. The most common balloon loans mature in 5 or 7 years. Sometimes balloon loans have features that allow borrowers to convert the mortgage at the end of the balloon period to a fully amortizing loan based upon the outstanding principal balance and the current interest rates. These loans are commonly called two-step mortgages. Generally, the interest rate on balloon loans is lower than 30- and 15-year mortgages resulting in lower initial monthly payments. However, after the initial balloon period, the interest rate will adjust based upon the current market conditions.
Adjustable Rate Mortgages (ARMs): The interest rate on ARMs adjusts periodically based upon an established index. The monthly payment adjusts at the same time the interest rate changes when ARMs are fully amortizing. Some ARMs may have an interest rate adjustment, but the monthly payment may not adjust; the difference or "shortfall" in interest may be added to the principal creating a Negative Amortizing Loan. In essence, the principal balance on the loan increases rather than decreases unless additional payments are made. ARMs have several important elements which are detailed below:
Index: The index is a published interest rate, such as the 1-year Treasury, 11th District Cost of Funds, or the London Inter-Bank Rate (LIBOR). The index is identified in the mortgage note.
Margins: The margin is a spread described as a percentage, which generally remains fixed during the loan. The margin is identified in the note and the current interest rate is based upon the index plus the margin.
Interest Rate: The interest rate is based upon the published index plus the margin. This is also known as the fully indexed mortgage interest rate. Refer to the index quote in the Wall Street Journal.
Periodic Interest Rate Caps: Most ARMs have caps on the interest rate adjustments depending on the adjustment period. Generally, a loan with a 6-month adjustment period will have a cap of 1% while a 1-year will have a 2% cap. However, there can be many variations of caps depending on the lender. The periodic interest rate cap is identified in the mortgage note
Life Cap: The life cap is the maximum interest rate the ARM may have during its life. The life cap is identified in the mortgage note.
Teaser Rate: Many times lenders will offer an introductory rate that is below the fully indexed rate.
Convertible ARMs: Sometimes lenders may offer a fixed rate conversion feature on an ARM allowing borrowers to convert to a fixed rate mortgage sometime in the future.
FHA Loans: The Federal Housing Administration (FHA) is sponsored by the U.S. Government and managed by the Housing and Urban Development (HUD). Most of the mortgage programs are designed for first time home buyers and low to moderate income borrowers. FHA offers fixed rate loans as well as ARMs. The down payment requirements of FHA loans are generally less than a conventional loan. Maximum loans can vary based on the metropolitan area and are established by FHA.
VA loans: The Veterans Administration (VA) is sponsored and managed by the U.S. Government. The VA establishes the maximum loan amounts and eligibility requirements. The major characteristic of a VA loan is that there is no down payment requirement up to the maximum loan amount.
State and Local Housing Programs: Many states, counties, and cities provide low to moderate housing finance programs. Most of these programs are fixed rate mortgages and have interest rates lower than the current market.