When buying a home, few individuals have enough money upfront to purchase the home. As a result, the majority of homeowners use a special loan called a mortgage to purchase their home. Mortgages are long-term loans, usually between 15 and 30 years long, which include the principal and an interest rate.
The principal of a mortgage is the term used to describe the total amount of the mortgage. For example, if you used a mortgage to purchase a $150,000 home with no down payment, the principal of the mortgage would be $150,000.
The interest rate of a mortgage is the way the bank or other loan holder makes their money. When you take the time to consider how much interest you pay on a home, it can sometimes cover the cost of the home several times, but this is the cost of not having enough money to buy the home upfront without a loan.
Depending on the type of mortgage, the interest rate is either fixed or adjustable. In a fixed rate mortgage, the interest rate remains the same for the entire length of the loan.
In an adjustable rate mortgage, the interest rate is adjusted, using the current interest rates as a metric, periodically over the course of a loan. Most adjustable rate mortgages have an interest rate that is adjusted once every 2 or 3 years, although this can vary, with some being adjusted every year and others only being adjusted once every 5 years.
Typically, an adjustable rate mortgage offers a lower initial interest rate and if the market is not preforming well, it is even possible for the interest rate to be lowered when it is adjusted, although this is not something you would want to bank on. Instead, it is a good idea to plan for the interest rate of an adjustable rate mortgage(ARM) to increase each time it is adjusted.
One very important part for prospective homeowners to consider when evaluating an ARM is how frequently the interest rate is adjusted, how much the interest rate can be adjusted each period, and how much the interest rate can be adjusted over the entire course of the mortgage.
Fixed Rate Mortgages, on the other hand, usually have a slightly higher interest rate, but offer the advantage of remaining the same for the entire length of the mortgage.
When evaluating options and trying to find the best deal on a mortgage, it is important to view an amortization table for the mortgage. An Amortization Table breaks down each payment for the entire length of the mortgage, showing how much the payment is and how much of the payment is going towards interest.
Over the course of the mortgage, the first several years go towards paying the interest of the mortgage. So, for several years, the overwhelming majority of each months payment is going towards interest. After about 5 to 10 years, this reverses and more of each payment is going towards the principal of the mortgage. By looking at an amortization table, you can tell when this switch will occur.
Using an online Amortization Table Generator, which most banks offer on their websites, can be an excellent tool not just for understanding the loan itself, but also for seeing how things like extra payments can affect the amount of interest you pay over the course of the loan.
In life, often buying a home is the biggest monetary investment a person will ever make. In most cases, especially in the United States, the homeowner does not have the money to purchase a home upfront, so uses a special type of loan called a mortgage. There are many types of mortgages, but, today, the Adjustable Rate Mortgage and the Fixed Rate Mortgage are the two most common kinds.
Mortgages are actually nothing new and date back many hundreds of years. However, over time, the rights of the homeowner has been increased and made stronger. In the times of Kings, the person who held the mortgage was, for all intensive purposes, the homeowner and had full control over the property until the mortgage was repaid. However, today, the bank is not considered the homeowner and can only take possession of the home if the loan holder does not pay, with even this not being a process without some judicial oversight.
Another change that has occurred recently is the types of mortgages used. The Fixed Rate Mortgage was, traditionally the primary type of home mortgage for many years, but today there are a number of other loan devices, of which the Adjustable Rate Mortgage is becoming more and more popular.
Fixed Rate Mortgages are much easier to understand than other types of loans. The loan holder has a fixed time that they must repay the loan by, usually 15 years or 30 years, and a fixed interest rate for this entire time. So, if you get a 30 year fixed rate mortgage at 6.5%, you will know that each mortgage payment for the next thirty years will be at the same rate.
Fixed Rate Mortgages offer a number of advantages, mainly that your interest rate can not usually be raised, well at least providing you make the payments. This makes it very easy to plan payments, while also protecting your investment against inflation and higher interest rates.
The Adjustable Rate Mortgage(ARM) is much new by comparison to fixed rate mortgages, first becoming popular in the early nineties. Adjustable Rate Mortgages are mortgages that have an interest rate that is adjusted every few years. The period of when the interest rate increases varies, but it is often every two or three years.
When an adjustable rate mortgage reaches its adjustment rate, the loan holder will change the interest rate to reflect the current market. Most ARMs are restricted to only raise one point(1%) each adjustment, but this is not always the case. It is possible for the interest rate to go down, such has been the case for many recently, but this is not something that should be counted on.
It is also possible that the interest rate will not raise the entire 1%, or whatever the limit is, but again this should not be counted on. In addition to having a limit of how much the interest rate can change with each adjustment, there is also usually a limit on how high the interest rate can raise over the course of the entire loan. For instance, there might be a 8% adjustment allowed over the entire course of the mortgage.
Since understanding how and ARM works can be a little difficult, it is often easier to look at an example adjustable rate mortgage and see how it works.
Take a 2 Year ARM that starts with an interest rate of 4.75%, which can be adjusted by 1% each period.
For the first two years of the mortgage, the interest rate will be at 4.75%. Then, after two years, the interest rate will be reevaluated and the current market will be taken into account. It will then be raised or lowered, keeping within the 1% limit, so for this example, lets assume it raises by the entire amount.
For the next two years, the interest rate will be 5.75%, which will again be reevaluated in 2 years.
There are a couple of advantages to using an ARM, but it is not always the best choice. The main advantage is that the introductory interest rate is usually lower than that of a fixed interest rate. So, the first few years will be lower, allowing the homeowner to put some extra money towards the principal of the loan or simply saving some money. Many people go with an ARM with the intention of paying their home down more rapidly or refinancing when the rates equal that of a standard fixed rate mortgage.
The ARM, and several variants, were one of the most abused loans during the recent real estate bubble bust, which resulted in many foreclosures.
There were a number of details that make an ARM subprime. One of the main factors was there was often no limit on how much the rate could increase, especially if the person missed a payment, which often forfeited many of their rights.
This lack of a ceiling on increases, especially when the homeowner had missed a payment, caused these subprime ARMs to rapidly increase. It was also not uncommon for people to get sucked into negative amortization ARMs, which basically mean the person was not paying all the interest on their loan, which was being tacked onto the end of the mortgage. As a result, each month the person would end up owing more on their loan.
For someone with less than perfect credit, it is often not possible to get a good rate on a Fixed Rate Mortgage, so an Adjustable Rate Mortgage might be the only option. ARMs also sometimes offer such a low initial interest rate that the there are literally hundreds of dollars in differences for the first few years. However, an Adjustable Rate Mortgage is not always the best choice.
It is important to always find out how much an ARM can increase each period and how much it can increase over the course of a loan. ARMs that have no limits, or with unrealistic limits, are most likely subprime, so this is an important consideration.
Purchasing a home is often the biggest investment a person will ever make, so it is not a decision that should be taken lightly. Most people do not have enough money saved up to purchase a home outright, so instead must rely upon a mortgage.
A mortgage is a type of loan, which uses the home as collateral. There are actually quite a few different types of mortgages, but the most common mortgages are Fixed-Rate Mortgages and Adjustable-Rate Mortgages.
The Fixed-Rate-Mortgage is sometimes referred to as a traditional mortgage. Fixed-Rate Mortgages are typically offered for durations of 15 or 30 years, although there are also some less standard durations including 10 and 20 years. Over the entire duration of a fixed rate mortgage, the interest rate does not change, so it is very easy to plan your monthly payments using an amortization table.
An Adjustable Rate Mortgage(ARM,) on the other hand, usually offers a low initial interest rate, but the interest rate is adjusted every few years.
Often, you will see Adjustable Rate Mortgages described using the format 5/1 ARM. The first number represents how often the rate of the ARM Increases. So, in the above example, the interest rate would be adjusted every 5 years. The second number represents the percent at which the interest rate can change, so in the above example, every five years, the interest rate would change by up to 1%.
While in most cases, the interest rate of an ARM will not decrease, it is possible. However, when considering going with an ARM, it is important to plan that the interest rate will increase each time. Another important consideration is what the maximum increase of the interest rate is over the course of the loan. Most lenders will provide a maximum of an 8% or 10% increase over the course of the mortgage, although this varies by lender.
Adjustable Rate Mortgages usually offer a lower initial interest rate, making them appear very attractive. However, as the rate increases, the monthly payment of the mortgage can quickly become very unfordable, so it is important to consider not just the initial rate, but how often the rate increases and what the monthly payment will be when the rate increases.
No matter what type of mortgage you go for, having at least 10% of the homes value for a down payment is very important. Traditionally, lenders had required a 20% down payment, but over the last 20 years, many lenders relaxed this requirement, with some even offering mortgages with 0% down.
However, due to our current economic situation, most lenders are returning to more traditional down payment requirements, so in many cases it will no longer be possible to get a mortgage without a down payment.
While having a down payment may now be a requirement for receiving a mortgage, this is not the only reason to save money for a down payment. This is because by having some money set aside, you will be able to get a lower interest rate and more favorable mortgage terms from your lender. With more options, you will be able to choose your lender, instead of having to go with a subprime mortgage lender. Not only will having money for a down payment mean there will be more options and more favorable terms, but it also means that you will have equity in your home as soon as you move in.