Financial Literacy 2007 - Mortgages
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Mortgage loan choices abound

Variety in mortgage offerings may ultimately be a boon to borrowers, but, at least at the start of the mortgage-shopping process, variety holds the potential for plenty of confusion. Here's a guide to some of the basics.

Always be aware that some lenders, in their desire to offer something the competition doesn't have, may offer loans that mix features in new -- and potentially confusing -- ways.

5 types of mortgages
  1. 30-year fixed rate.
  2. One-year adjustable-rate, or ARM.
  3. Hybrid.
  4. Interest-only.
  5. Payment-option loans.

30-year fixed rate mortgage

The traditional mortgage remains a favorite of borrowers. Although the interest rate is generally higher than the starting rates on other loan types, your interest rate and payment will remain fixed for 30 years with this type of loan, and that's a boon to planning your long-term finances.

A variety on this is a fixed-rate loan with a term of 15 or 20 years. Required monthly payments on these loans will be significantly higher than on a 30-year fixed, but you will build equity faster and, in the long term, pay much less in interest. Most lenders allow you to prepay principal on a 30-year loan, so you can retire the debt earlier. Some lenders also offer 40-year terms, which lowers the monthly payment, but stretches out your indebtedness significantly and boosts the total amount you will have spent on interest.

One-year adjustable-rate mortgage, or ARM

This is the original variety of an adjustable rate mortgage, commonly referred to as an ARM.

Important ARM factors
IndexFrequency of rate adjustment
MarginAnnual and life-of-loan caps
CapsPayment caps

A one-year ARM has a 30-year term, but your interest rate will adjust every year. The interest rate will be determined by the index that your loan is pegged to, typically one-year Treasury rates or the LIBOR index (an acronym for the London Interbank Offered Rate) or the COFI index (Federal Reserve Cost of Funds Index). LIBOR and COFI indexes also are used frequently for mortgages that adjust their interest rates more frequently than once a year.

To determine your new interest rate each year, the lender will add a specific margin, say 2.75 percentage points, to that index. However, borrowers are protected from wild run-ups in interest rates by two important caps that are called for in most loan documents. Typically, your rate can rise (or fall -- it does happen) by no more than 2 percentage points each year, and over the life of the loan it can rise by no more than 6 percentage points. Most ARMs start with below-market "teaser" rates, so you should expect your interest rate will rise at its first and possibly second anniversary.

With any ARM, it is important to note how frequently the interest rate can adjust (it can be as frequently as every month with some varieties), plus the index and the margin used to set the new interest rate. Always check for annual and life-of-loan caps on the interest rate. If the loan documents talk about payment caps -- that means your interest rate changes are unlimited. If you pay only the capped payment, you might not be paying enough to cover the interest that is actually being charged on the loan. That unpaid interest gets added to your loan balance, a practice called negative amortization. Your loan balance grows even as you're making the required monthly payment, and that's a risky financial practice.


Hybrid mortgages

Sometimes called a "three-year fixed" or a "five-year fixed," these loans incorporate some of the features of fixed- and adjustable-rate loans. For example, a basic "3/27 hybrid" loan will offer you a rate that is fixed for the first three years and then converts to a one-year ARM for the remaining 27 years of the full 30-year term.


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