Executive Mortgage – Jen LeVea

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Choosing A Mortgage Program

There isn't a single or simple answer to this question. The right type of mortgage for you depends on many different factors, such as:

Your current financial picture.
How you expect your finances to change.
How long you intend to keep your house.
How comfortable you are with your mortgage payment changing.

For example, a 15-year fixed-rate mortgage can save you many thousands of dollars in interest payments over the life of the loan, but your monthly payments will be higher. An adjustable rate mortgage may get you started with a lower monthly payment than a fixed-rate mortgage--but your payments could get higher when the interest rate changes.

The best way to find the "right" answer is to discuss your finances, your plans and financial prospects and your preferences frankly with a mortgage professional.

Fixed Rate Mortgages
This is the most common mortgage program. 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.

Adjustable Rate Mortgages (ARM)
These loans generally begin with an interest rate that is 2 to 3% below a comparable fixed rate mortgage and could allow you to buy a more expensive home.

However, the interest rate changes at specified intervals (for example, every year) depending on changing market conditions; if interest rates go up, your monthly mortgage payment will go up. If rates go down, your mortgage payment will drop.

Special ARMs
There are also mortgages that combine aspects of fixed and adjustable rate mortgages - starting at a low fixed-rate for seven to ten years, for example, then adjusting to market conditions. Ask your mortgage professional about these and other special kinds of mortgages that fit your specific financial situation.
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
This type of ARM has a maximum interest rate adjustment of 1% every 6 months. The 6-month (CD) index is generally considered to react quickly to changes in the market.
1-Year Treasury Spot ARM
The 1-year Treasury Spot ARM has as a maximum interest rate adjustment of 2% every 12 months. This index generally reacts more slowly than the CD index, but more quickly than the Treasury Average index.
6-Month Treasury Average ARM
This index has a maximum interest rate adjustment of 1% every 6 months. It 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
The 12-month Treasury Average ARM has a maximum interest rate adjustment of 2% every 12 months. It 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
These are the most adjustable rate loans (ARMs) and 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.

ARM Glossary of Terms
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 6 months or a year. There are loans that have interest rate caps of 3 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.

Balloon Mortgages
Balloon loans are short term mortgages that have some features of a fixed rate mortgage. The loans provide a level payment feature during the term of the loan but, as opposed to the 30 year fixed rate mortgage, balloon loans do not fully amortize over the original term. Balloon loans can have many types of maturities; most balloons that are first mortgages have a term of 5 to 7 years.

At the end of the loan term, there is still a remaining principal loan balance and the mortgage company generally requires that the loan be paid in full; this can be accomplished by refinancing. Many companies have other options such as a conversion feature at the end of the term.

For example, the loan may convert to a 30 year fixed loan at the 30 year market rate plus 3/8 of a percentage point. Your conversion can be guaranteed based on certain criteria, such as having made your last 24 payments on time. The balloon mortgage program with the conversion option is often called a 7/23 Convertible or 5/25 Convertible.

Buydown Options
The most common buydown is the 2-1 buydown. In the past, for a buyer to secure a 2-1 buydown, they would pay 3 points above current market points in order to pay a below-market interest rate during the first 2 years of the loan. At the end of the 2 years, they would then pay the old market rate for the remaining term.

As an example, if the current market rate for a conforming fixed rate loan is 8.5% at a cost of 1.5 points, the buydown gives the borrower a first year rate of 6.50%, a second year rate of 7.50%, and a third through 30th year rate of 8.50%, and the cost would be 4.5 points. Buydowns used to be paid for by a transferring company because of the high points associated with them.

In today's market, mortgage companies have designed variations of the old buydowns. Rather than charge higher points to the buyer in the beginning, they increase the note rate to cover their yields in the later years.

As an example, if the current rate for a conforming fixed rate loan is 8.50% at a cost of 1.5 points, the buydown would give the buyer a first year rate of 7.25%, a second year rate of 8.25% and a third through 30th year rate of 9.25%, or a three-quarter point higher note rate than the current market--and the cost would remain at 1.5 points.

Another common buydown is the 3-2-1 buydown which works much in the same way as the 2-1 buydown, with the exception of the starting interest rate being 3% below the note rate. Another variation is the flex-fixed buydown programs that increase at 6-month intervals rather than annual intervals.

As an example, for a flex-fixed jumbo buydown at a cost of 1.5 points, the first 6 months' rate would be 7.50%, the second 6 months' rate would be 8.00%, the next 6 months' rate would be 8.50%, the next 6 months' rate would be 9.00%, durng the next 6 months the rate would be 9.50%, and at the 37th month, the rate would reach the note rate of 9.875% and would remain there for the remainder of the term. A comparable jumbo 30 year fixed at 1.5 points would be 8.875%.

Graduated Payment Mortgage (GPM)
The GPM is another alternative to the conventional adjustable rate mortgage. It is making a comeback as borrowers and mortgage companies seek alternatives to assist in qualify for home financing.

Unlike an ARM, GPMs have a fixed note rate and payment schedule. With a GPM, the payments are usually fixed for 1 year at a time. Each year for 5 years the payments graduate at 7.5% to 12.5% of the previous year's payment.

GPMs are available in 30 year and 15 year amortization and for both conforming and jumbo loans. With the graduated payments and a fixed note rate, GPMs have scheduled negative amortization of approximately 10% to 12% of the loan amount depending on the note rate. The higher the note rate, the larger degree of negative amortization. This compares to the possible negative amortization of a monthly adjusting ARM of 10% of the loan amount. Both loans give the consumer the ability to pay the additional principal and avoid the negative amortization. In contrast, the GPM has a fixed payment schedule so the additional principal payments reduce the term of the loan. The ARMs additional payments avoid the negative amortization and the payments decrease while the term of the loan remains constant.

The scheduled negative amortization on a GPM differs depending on the amortization schedule, the note rate, and the payment increases of the loan. GPM loans with 7.5% annual payment increases offer the lowest qualifying rate but the largest amount of negative amortization.

For example, on a loan of $150,000 with a 30 year amortization and a note rate of 10.50% with 12.5% annual payment increases, the negative amortization continues for 60 months. The qualifying rate is 5.75% and the negative amortization is 11.34% (approximately $17,010).

The note rate of a GPM is traditionally half to three-quarters of a percent higher than the note rate of a straight fixed rate mortgage. The higher note rate and scheduled negative amortization of the GPM makes the cost of the mortgage more expensive to the borrower in the long run. In addition, the borrower's monthly payment can increase by as much as 50% by the final payment adjustment.

The lower qualifying rate of the GPM can help borrowers maximize their purchasing power and can be useful in a market with rapid appreciation. In markets where appreciation is moderate and a borrower needs to move during the scheduled negative amortization period, they could create an unpleasant situation.

Terry Thomas of Executive Mortgage

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