The best type of mortgage loan really depends on the personal financial situation of the borrower. Fixed rate loans give you the peace of mind of knowing that your monthly payment will never change. ARM loans offer lower payments than fixed rate loans initially and the opportunity to see your payments decrease if interest rates decrease but they also carry the risk that payments will increase at some point in the future. There are also hybrid loans which offer a fixed rate initially but will then become ARM loans at some point in the future.
Fixed Rate Mortgages
The most common type of mortgage loan is the fixed rate loan. The payments for a fixed rate mortgage are divided up as equal monthly payments over the term of the loan. The interest rate stays exactly the same over the duration of the loan and the size of the payment never changes. This is the advantage of the fixed rate mortgage. The borrower is protected from future interest rate increases and easier make budgeting decisions knowing that the payment will always be the same.
Fixed Rate Loan Duration
Typically fixed rate loans are available as 30 year mortgages, 20 year mortgages, 15 year mortgages, and 10 year mortgages. The 30 year fixed rate mortgages is by far the most popular because it has the lowest payment out of all of these options. With shorter duration loans the interest rate typically will be lower because shorter duration loans almost always carry less risk for the lender. Even with the lower interest rates though your payments will always be higher because the borrower is paying more principal in each payment in shorter duration loan.
To get a good feel for how the length of the loan affects the size of the payments and the amount of interest paid use the mortgage calculator. For example at the time of the writing of this article, the average interest rate for a 30-year loan in the US is 3.80%, so if we enter this into the mortgage calculator we get a monthly payment of $931.91 and we get $135,489.29 for the total interest over the lifetime of the loan. Now if we change just the term of the loan to 20-years without changing any other value and click “Calculate”, we get a monthly payment of $1,190.99 which is much higher but the total interest paid over the term of the loan is only 85,836.97. So in exchange for taking on a 28% higher monthly payment you are paying 37% less interest over the course of the loan.
In the above scenario we assumed that the 30 year interest rate is the same as the 20 year interest rate, which isn’t usually true. You would usually pay a lower interest rate on a 20 year loan than for a 30 year loan. Currently a 20 year loan can be obtained with an interest rate of 3.426%. When we plug in this rate for a 20 year mortgage into the mortgage calculator we get a monthly payment of $1,152.33 and a total interest value of $76,558.90, so with these rates the actual total interest savings from going with a 20 year loan instead of a 30 year loan would be about 43% in exchange for paying an extra $220 a month in payments using this example. Here is a table of what the interest rates and total interest would be using the rates available at the time of this writing for each of the popular fixed-rate loan terms on a $200,000 mortgage:
As you can see, the savings in terms of total interest can be substantial by choosing a shorter loan term. Despite this, most borrowers in the U.S. opt for a 30 year mortgage because they want to see a lower monthly payment.
Adjustable Rate Mortgages
An adjustable-rate mortgage is a mortgage (ARM), that has an interest rate that can change over time. The advantage of taking an adjustable rate mortgage is that an adjustable rate mortgage will typically be offered at a lower interest rate than a fixed rate mortgage with an equivalent duration. For example at the time of this writing, an 30-year fixed rate loan can be obtained at around a 3.80% interest rate, while an ARM loans are available from anywhere between 2.3% to 3.0% which will result in a significantly lower monthly payment. The interest rates are lower for adjustable rate mortgages because they are less risky for the lender. The value of the mortgage to the lender will not decrease as interest rates increase. The risk of interest rate increases is born by the borrower with an adjustable rate mortgage. The interest rate adjustment happens once a year. When the mortgage adjusts to the current interest rate, the borrower’s payment may go up or down depending on what direction interest rates have moved.
Hybrid ARM Loans
Most ARM loans are actually hybrid loans. The basic 1/1 ARM loan that adjusts every year starting with the first year is not very popular with borrowers. Most borrowers end up getting a hybrid adjustable rate mortgage. These loans typically start out as a fixed-rate loan for a number of years and then becomes an adjustable rate loan at some point in the future. A typical hybrid ARM is the 5/1 ARM. This is a mortgage that has 5 years of fixed rates and then adjusts every year after that. Other examples are the 3/1 ARM and 7/1 ARM which are fixed for 3 years and 7 years respectively.
Definition of the index for an ARM
The interest rate for an adjustable rate mortgage is calculated as a margin rate which is added to some interest rate index. The index could be any common short-term interest rate that is widely traded in the financial markets, and is out of the control of the lender since it is set by market forces. For example the index might be the 1 year average interest rate of a 1-year US Treasury bond. Another common index is called LIBOR which is the London Interbank Offer Rate, and is an interest rate which certain large financial institutions can lend money to each other for short durations. The index may sound complicated, but the important take-away is that the index is some short-term interest rate that is widely published and set by markets not your lender. The index changes constantly and this change in the index is what causes the interest rate of the loan to change when it adjusts.
Definition of the Margin for an ARM
The margin for an ARM is simply some value that is added to the index to get the actual interest rate that the borrower will pay. So for example, if an ARM loan is indexed to the 1-year LIBOR rate and the margin of the loan is 1.89% when LIBOR is 0.79% on the day that the mortgage adjusts, then the interest rate on the ARM loan for the next year will be 0.79%+1.89%=2.68%. If the next year after that, if LIBOR has risen to 1.4%, then the new mortgage rate on this example ARM loan over the next year would be 1.4%+1.89%=3.29%. The margin always stays the same for the life of the loan. If is the index that changes over time, and causes the mortgage rate to change along with it.
Adjustable Rate Mortgage Cap
Most ARM loans have a cap on the amount that the interest rate can change in any given year. The cap limits how high the interest rate on an adjustable rate mortgage may increase in any given year. So for example, take our example ARM loan from the previous paragraph that is indexed to 1-year LIBOR and has a margin of 1.89%.. Let’s say that this loan has a 2% cap. If LIBOR starts out at 0.79% the first year then the first year interest rate will be 2.68%. If LIBOR increases to 3.79% the following year, the new mortgage rate will only be 2.79%+1.89%=4.68% instead of 3.79%+1.89%=5.68% because LIBOR’s change in 1 year was greater than the 2% cap, so the rate maxes out with only a 2% increase year over year. Typically there will be a higher cap for the first adjustment, and a lower cap for all subsequent adjustments for adjustable rate mortgages. There will also often be a life-time cap on the interest rate for the ARM loan. From the borrower’s perspective, It is desirable to have a lower cap, but since this increases the risk for the lender, loans with a lower cap will generally have a higher margin than loans with a larger cap.
Interest Only Mortgages
Interest only mortgages are loans which for some fixed period of time, the borrower does not have to pay any principal on the loan. This has the effect of initially lowering the monthly payment for the loan. Usually, the interest-only period of the loan is five or ten years. Depending on the type of interest only loan, there are 3 things that can happen after the interest-only period has completed:
- The loan may become a fixed rate loan amortized over the remaining duration of the loan.
- The mortgage may become an ARM loan for the remaining period of the loan.
- The balance of the principal may be due immediately as one large balloon payment.
In all cases, when a borrower takes out an interest-only loan, the borrower is exchanging lower payments at the beginning of the loan for higher payments later in the loan. The payments will always be higher during the later portion of the interest-only loan than if the borrower had taken out a conventional type of fixed-rate or ARM loan. This is because with the interest-only loan, a larger principal balance always remains to be paid-off during a shorter duration after the interest-only portion is completed.
The Risks of an Interest-Only Mortgage
In theory, an interest-only mortgage can make sense in certain cases. It is often said that these types of mortgages can make sense for people expecting to make a higher income in the future, or for people who plan on selling their houses before the interest-only period ends, but this is risky. Taking out an interest-only mortgage because you expect to be making more money in the future or because you think you will be able to sell your house at some point in the future are both forms of speculation. The future doesn’t always turn out the way we expect. If you cannot afford to buy a property without taking out an interest-only loan it is probably safer to not buy the property until you can afford it with a more conventional type of loan.