Types of Mortgages
There are many different types of mortgages out there. We will discuss the types most commonly associated with home financing here in California. Lenders may use different catchy names to describe their products, but for the most part, they all have the same options available.
First off, what's a mortgage? It is a temporary, conditional pledge of property to a creditor as security for performance of an obligation or repayment of a debt.
The most important numbers involved in a mortgage which have a direct effect on the borrower are the term and interest rate.
The term: how long is the time period for repayment? There are 7, 10, 15, 20, 30, 40 and 50 year terms available. A loan with a 30 year term that is fully amortized* will be paid off in 30 years.
* Fully amortized means the loan balance will be paid off at the end of the loan. The longer the term, the lower the payment, and typically, the longer the term, the higher the interest rate.
For those who like math: looking at the 15 year loan, take 180 months of payments for the 15 year term, multiply it by the payment (180 x $2,531.57). Take the total of all the payments and subtract the principal balance, ($455,682.60 - $300,000). And you get the amount of interest paid on the loan which is $155,682.60
The interest rate: this is the cost of borrowing the money. If your chosen rate is 6%, then you can think of it as, ‘it costs me 6% to "use" that loaned money’. The interest rate can make a huge difference on the cost associated with keeping a mortgage for a long period of time. To demonstrate, let's compare the amount of interest paid for a $300,000 loan with a 5.5%, 5.75% and 6% interest rate with a 30 year term.
Types of mortgages. At PCMC, we have fixed rate mortgages of varied terms, as well as different types of ARMs (Adjustable Rate Mortgages).
Fixed rate mortgage is the most commonly used loan, and of the fixed rate loans, the 30-year fixed is the most widely used today. These are seen as not very exciting, but simple and stable (you know what your payment will be for the next 30 years). A 30-year fixed loan of $300,000 at 6% will have a monthly payment of $1,798.65. When you make this payment for the next 360 months, the loan will be paid off, and we can have an old fashioned mortgage burning party.
ARMs (Adjustable Rate Mortgages) are also a fairly common these days. This type of loan is a bit more complicated than the one mentioned above in that it is fixed for a predetermined amount of time, generally 1, 2, 3, 5, 7 or 10 years; after the fixed period, it adjusts to the market, based on the margin and the index the loan is tied to.
Example: 5/1 LIBOR ARM at 6% with a 30 year term, loan amount of $300,000 with a margin of 2.25 and the index being the 6-month LIBOR (London Inter Bank Offering Rate).
For 5 years, aka the first 60 months, the payment will be based on the 6% interest rate, yielding a monthly payment of $1,798.65. The 61st payment will readjust to the market. So if the 6-month LIBOR is at 5.2 at this time, the new interest rate will be the margin + the index (2.25 + 5.2), or 7.45%. The new payment on the 61st month will be based on the 25 years remaining at 7.45% with a principal balance of $279,163.14. Your payment will be $2,053.92. It could just as easily go down. If the 6-month LIBOR is at 3.4 on the 61st month, the new rate would be margin + index (2.25 + 3.4), 5.65% and the payment would be $1739.40. The most important thing to note about ARM mortgages is that they adjust every year after the first adjustment and sometimes twice a year.
Not to complicate things even further, but the majority of ARMS have adjustment caps, typically 1-2% per adjustment. If our loan above had a cap of 1% per adjustment, then the highest the interest rate would go up or down would be 1% per adjustment. In the case of the 6-month LIBOR being at 5.2 on the 61st month, the rate will go to 7% and the payment would be $1,973.07. It really depends on how your mortgage professional sets up your loan. If your best interests are taken into consideration, the loan can be set up to suit your specific needs. This is where an honest mortgage broker becomes valuable to you.