Choosing a Mortgage

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Choosing a Mortgage

Choosing a mortgage that’s right for you

Like homes, mortgages come in many sizes and types. The type of mortgage that’s right for you depends on many factors, such as your tolerance for risk and how long you expect to stay in your home.

Conventional fixed rate mortgages

As the name implies, the interest rate on a fixed rate mortgage remains the same throughout the life of the loan. Your monthly payment (consisting of principal and interest) generally remains the same as well. The entire mortgage is repaid in equal monthly installments over the term (length) of the loan. For this reason, fixed rate mortgages often appeal to individuals with a low tolerance for the risk associated with fluctuating monthly payments. The usual terms for fixed rate mortgages are 15 and 30 years.

Adjustable rate mortgages (ARMs)

With an ARM, also called a variable rate mortgage, your interest rate is adjusted periodically, rising or falling to keep pace with changes in market interest rate fluctuations. Since the term of your mortgage remains constant, the amount necessary to pay off your loan by the end of the term changes as your loan’s interest rate changes. Thus, your monthly payment amount is recalculated with each rate adjustment.

Depending on what’s specified in the mortgage contract, an ARM can be adjusted semi-annually, quarterly, or even monthly, but most are adjusted annually. The adjustments are made on the basis of a formula specified in the mortgage contract. To adjust the rate, the lender uses an index that reflects general interest rate trends, such as the one-year Treasury securities index, and adds to it a margin reflecting the lender’s profit (or markup) on the money loaned to you. Thus, if the index is 5.75 percent and the markup is 2.25 percent, the ARM interest rate would be 8 percent.

What’s to keep the interest rate from going through the roof–or, for that matter, from plunging through the floor? Most ARMs specify interest rate caps. The periodic adjustment cap may limit the amount of rate change, up or down, allowed at any single adjustment period. A lifetime cap may indicate that the interest rate may not go any higher–or lower–than a specified percentage over–or under–the initial interest rate.

The initial interest rates (referred to as teaser rates) on ARMs are generally lower than the rates on fixed rate mortgages. An ARM may be a good option for an individual who can tolerate uncertainty in his or her mortgage interest rate and fluctuations in his or her monthly mortgage payment amount or plans to live in his or her home for only a short period of time.

Hybrid ARMs

Hybrid ARMs are mortgage loans that offer a fixed interest rate for a certain time period (3, 5, 7, or 10 years), and then convert to a 1-year ARM.

The initial fixed interest rate on a hybrid ARM is often considerably lower than the rate on either a 15-year or 30-year fixed rate mortgage. The longer the initial fixed-rate term, however, the higher the interest rate for that term will be. Generally speaking, even the lowest of these fixed rates is higher than the initial (teaser) rate of a conventional 1-year ARM.

Hybrid ARMs are ideal for individuals who plan to stay in their homes for a short period of time (3 to 10 years), since they can take advantage of the low initial fixed interest rate without worrying about how the loan will change when it converts to an ARM. If you think your plans may change or you are planning on staying put for a while, look for a hybrid ARM with a conversion option. This option will allow you to convert your loan to a fixed rate loan before it turns into an ARM.

Government mortgage programs

Generally, government mortgage programs offer mortgages insured and/or guaranteed by agencies of the federal government. Some of the advantages of these types of mortgages include:

  • Fixed interest rates that are lower than those offered by conventional loans
  • Little or no down payment required
  • Less stringent qualifying guidelines than conventional loans

FHA loans

Federal Housing Administration (FHA) mortgages are similar to conventional fixed rate mortgages, except that they are insured by the federal government. A Federal Housing Administration (FHA) mortgage may allow a down payment of as little as 3.5 percent. Keep in mind, however, that FHA loans require borrowers with down payments of less than 20% to pay mortgage insurance premiums.

FHA mortgage amounts are limited, and the maximum loan amount varies among geographic regions.

VA loans

The Department of Veterans Affairs (VA) mortgages are similar to conventional fixed rate mortgages. VA mortgages are available to qualified veterans and their surviving spouses.

VA loan limits vary, depending on location. Generally, a lender will offer a VA loan equal to four times a veteran’s available entitlement (provided certain underwriting requirements are met). Currently, the basic entitlement for veterans is $36,000. You can visit http://benefits.va.gov/homeloans for more information.

Jumbo loans

A jumbo loan (also known as a nonconforming loan) is any mortgage over $417,000, or over $625,5000 in the most expensive parts of the country, for a single-family home or condominium. This figure is set by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), and is adjusted annually. Jumbo loans are called nonconforming loans because these organizations will not underwrite them, making them more risky to lenders. As a result, lenders often set their jumbo loan interest rates higher than conventional mortgage rates.

If you’re just over the underwriting limit for conforming loans and are having to consider a jumbo loan, you might want to either look for a less expensive house or consider increasing your down payment in order to qualify for a conforming loan with a lower interest rate. Over the life of your mortgage, a lower interest rate could create significant savings.