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Fixed Rate Mortgages
The most common type of mortgage program where your monthly payments for interest and principal never change. Property taxes and homeowners insurance may increase, but generally your monthly payments will be very stable.
Fixed-rate mortgages are available for 30 years, 20 years, 15 years and even 10 years. There are also "bi-weekly" mortgages, which shorten the loan by calling for half the monthly payment every two weeks. (Since there are 52 weeks in a year, you make 26 payments, or 13 "months" worth, every year.)
Fixed rate fully amortizing loans have two distinct features. First, the interest rate remains fixed for the life of the loan. Secondly, the payments remain level for the life of the loan and are structured to repay the loan at the end of the loan term. The most common fixed rate loans are 15 year and 30 year mortgages.
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 fixed rate mortgage takes 22.5 years of level payments to pay half of the original loan amount.
Should Interest Only Loans…Interest You?
Just a few short years ago, less than one out of every ten home mortgages taken out were considered “Interest-Only” loans. But today, more than one out of every four loans are Interest-Only mortgages. What is this “Interest Only” anyways, and why all the increased attention?
As the name would suggest, and similar to the way a home equity line of credit works, the only payment required on an Interest-Only home loan is one that will cover only the interest due, usually for the first ten years. No payment is required to be made toward the principle, so the mortgage balance may remain exactly the same as when the loan was taken out. After ten years, the remaining mortgage balance is then paid off over the remaining twenty years of the loan term. Sounds interesting, right? Let’s take a closer look.
Pay Me Now or Pay Me Later
On a standard 30-year Fixed Rate home loan, a $200,000 loan at a 6% interest rate would have a principle and interest payment of about $1200 per month. An Interest Only mortgage generally does carry a slightly higher rate, so by contrast, that $200,000 loan would run around 6.125%…but the payment required would be about $1021 per month, to cover the interest for the first ten years. However, if no payment were made to the principle balance of the loan during the initial ten years, the remaining balance would all have to be paid over the final twenty years of the loan. The new principle and interest payment required would then jump to about $1433 per month. Of course you can choose to pay towards the principle at any time…but most people just enjoy that smaller payment every month.
And the monthly payment shouldn’t be the only consideration. If you were to sell or refinance within the first ten or twenty years, the loan that included a payment toward the principle would have a much lower remaining balance, and therefore give you more equity to help with down payment on a future home…or whatever else you might decide to use that money for. In fact, after ten years of repayment on a typical home loan that includes principle and interest payments, the remaining loan balance would be about $167,000, giving you an extra $33,000 in equity.
So Many Loans, So Little Time
The fixed rate example above is just one of the many Interest-Only options available. Interest-Only loans can also be taken on an Adjustable Rate basis, commonly referred to as ARM’s. With an ARM, the start rate is lower than on a Fixed, but the rate can change and payments may increase over time. An Interest-Only ARM makes the short-term payment savings even greater, but does have an added element of rate change risk.
Another type of Interest-Only loan is commonly called the “Option ARM”, which gives you the option to make a regular payment covering principle and interest, an interest-only payment, or even a payment that does not cover the full amount of interest due. In this case, the unpaid interest is tacked onto the loan balance, which actually increases the outstanding loan amount over time. This is known as “negative amortization”. To go back to our example, our $200,000 loan could have a minimum payment due of $333, which is a whopping $867 monthly payment reduction over a normal loan! It’s little wonder that these loans have become so popular. But the attractive payment comes with a kicker, as you may be adding tens of thousands of dollars to the balance you owe on your mortgage. Meanwhile, you are hoping that you can keep your loan balance neck and neck with home appreciation rates so you don’t end up “upside down” on your home, owing more than it is worth.
Interesting…So Who Is This Loan Good For?
Interest-Only loans are not for everyone, but you can absolutely benefit from these types of loans, if you are wise and disciplined. By properly managing the monthly cash flow savings you gain with an Interest-Only loan, the difference can be invested for greater returns. But wise choices must be made, and discipline must be used, as it would be very easy to let the payment savings simply slide away unnoticed into the checking account every month.
There are others who can benefit as well, like those individuals who expect income to increase over the near term. For example, a spouse may be taking time off from the job to stay home with children, but will return to the workforce in a few years. Others may be anticipating a promotion or completion of schooling a few years down the road. The smaller initial payment required on an Interest-Only loan can provide the opportunity to get into a home with a more manageable monthly payment when it is needed most in the early years, rather than waiting on the sidelines and not purchasing a home at all.
Makes Sense…But Who Is This Not Good For?
Many simply cannot resist the allure of the smaller initial payment, but this loan is not right for everyone. If you are unable to add to your savings on a consistent basis, can’t pay your credit cards off in full, or don’t expect your earnings to increase in the coming years…then be cautious before selecting an Interest-Only loan.
With so many loan options available, it’s always best to talk with a mortgage professional who can clearly explain the different programs available, and help you select the one that is best for YOU.
Standard ARM Programs
A few options are available to fit your individual needs and your risk tolerance with the various market instruments.
ARMs with different indexes are available for both purchases and refinances. Choosing an ARM with an index that reacts quickly lets you take full advantage of falling interest rates. An index that lags behind the market lets you take advantage of lower rates after market rates have started to adjust upward.
The interest rate and monthly payment can change based on adjustments to the index rate.
6-Month Certificate of Deposit (CD) ARM
Has a maximum interest rate adjustment of 1% every six months. The 6-month Certificate of Deposit (CD) index is generally considered to react quickly to changes in the market.
1-Year Treasury Spot ARM
Has a maximum interest rate adjustment of 2% every 12 months. The 1-Year Treasury Spot index generally reacts more slowly than the CD index, but more quickly than the Treasury Average index.
6-Month Treasury Average ARM
Has a maximum interest rate adjustment of 1% every six months. The Treasury Average index generally reacts more slowly in fluctuating markets so adjustments in the ARM interest rate will lag behind some other market indicators.
12-Month Treasury Average ARM
Has a maximum interest rate adjustment of 2% every 12 months. The treasury Average index generally reacts more slowly in fluctuating markets so adjustments in the ARM interest rate will lag behind some other market indicators.
Introductory Rate ARM's
Most adjustable rate loans (ARMs) have a low introductory rate or start rate, some times as much as 5.0% below the current market rate of a fixed loan. This start rate is usually good from 1 month to as long as 10 years. As a rule the lower the start rate the shorter the time before the loan makes its first adjustment.
Index - The index of an ARM is the financial instrument that the loan is "tied" to, or adjusted to. The most common indices, or, indexes are the 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI). Each of these indices move up or down based on conditions of the financial markets.
Margin - The margin is one of the most important aspects of ARMs because it is added to the index to determine the interest rate that you pay. The margin added to the index is known as the fully indexed rate. As an example if the current index value is 5.50% and your loan has a margin of 2.5%, your fully indexed rate is 8.00%. Margins on loans range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property value.
Interim Caps - All adjustable rate loans carry interim caps. Many ARMs have interest rate caps of six-months or a year. There are loans that have interest rate caps of three years. Interest rate caps are beneficial in rising interest rate markets, but can also keep your interest rate higher than the fully indexed rate if rates are falling rapidly.
Payment Caps - Some loans have payment caps instead of interest rate caps. These loans reduce payment shock in a rising interest rate market, but can also lead to deferred interest or "negative amortization". These loans generally cap your annual payment increases to 7.5% of the previous payment.
Lifetime Caps - Almost all ARMs have a maximum interest rate or lifetime interest rate cap. The lifetime cap varies from company to company and loan to loan. Loans with low lifetime caps usually have higher margins, and the reverse is also true. Those loans that carry low margins often have higher lifetime caps.
COFI ARM Cost of Funds Index
The 11th District Cost of Funds is more prevalent in the West and the 1-Year Treasury Security is more prevalent in the East. Buyers prefer the slowly moving 11th District Cost of Funds and investors prefer the 1-Year Treasury Security.
The monthly weighted average Eleventh District has been published by the Federal Home Loan Bank of San Francisco since August 1981. Currently more than one half of the savings institutions loans made in California are tied to the 11th District Cost of Funds (COF) index.
The Federal Home Loan Bank's 11th District is comprised of saving institutions in Arizona, California and Nevada.
Few people who use and follow the 11th District Cost of Funds understand exactly how it is calculated, what it represents, how it moves and what factors affect it.
The predecessor to the 11th District Cost of Funds index was the District semiannual weighted average cost of funds published for a six month period ending in June and December. The San Francisco Bank was the first Federal Home Loan Bank to publish a monthly cost of funds index.
The funds used as a basis for the calculation of the 11th District Cost of Funds index are the liabilities at the District savings institutions: money on deposit at the institutions, money borrowed from a Federal Home Loan Bank (known as advances) and all other money borrowed. The interest paid on these types of funds is the cost of these funds.
The ratio of the dollar amount paid in interest during the month to the average dollar amount of the funds for that month constitutes the weighted average cost of funds ratio for that month.
The average cost of funds is said to be weighted because the three kinds of funds and their costs are added together before a ratio is computed rather than calculating averages individually for the three sources and using a simple average of the three ratios. This gives the greatest weight to the interest paid on deposits, and explains the delayed reaction of the index to rising fixed-rate mortgages.
LIBOR
LIBOR, London InterBank Offered Rate, is the rate on dollar-denominated deposits, also know as Eurodollars, traded between banks in London. The index is quoted for one month, three months, six months as well as one-year periods.
LIBOR is the base interest rate paid on deposits between banks in the Eurodollar market. A Eurodollar is a dollar deposited in a bank in a country where the currency is not the dollar. The Eurodollar market has been around for over 40 years and is a major component of the International financial market. London is the center of the Euromarket in terms of volume.
The LIBOR rate quoted in the Wall Street Journal is an average of rate quotes from five major banks. Bank of America, Barclays, Bank of Tokyo, Deutsche Bank and Swiss Bank.
The most common quote for mortgages is the 6-month quote. LIBOR's cost of money is a widely monitored international interest rate indicator. LIBOR is currently being used by both Fannie Mae and Freddie Mac as an index on the loans they purchase.
LIBOR is quoted daily in the Wall Street Journal's Money Rates and compares most closely to the 1-Year Treasury Security index. Feel free to contact me if I can be of any assistance!
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