In addition to the loan term, loan types are differentiated by the way the payment is structured. The most common mortgage loan payment structures are:
Fixed Rate Mortgages. With a fixed rate mortgage, the interest rate and the payment (excluding property taxes and insurance) are fixed, or stable, for the life of the loan. That is, if you get a $200,000 loan at 6% interest for 30 years, you know you’ll pay about $1200 each month for principle and interest for as long as you choose to keep the property and the loan. Historically, most mortgage loans in the U.S. have been fixed rate loans.
Adjustable Rate Mortgages (ARM). With an ARM, the interest rate and monthly payment (excluding property taxes and insurance) are fixed for a specified initial time frame and then adjust at specified intervals to follow changes in market interest rates either upward or downward. The initial fixed rate period may only be a month or two, or it may be several years. Once the initial fixed rate period is over, most ARMs adjust yearly, but many adjust monthly or biannually. If you see a loan marketed as a 5/1 ARM, this typically means it has an initial fixed period of 5, 7 or 10 years and then adjusts annually. Interest rates on ARMs are almost always lower than rates for fixed mortgages, since the borrower is sharing the investor’s risks regarding long term interest rates changes. Generally, the shorter the initial fixed period and the more frequent the adjustments, the bigger the difference between the ARM rate and the fixed rate. Depending on market forces, the interest rate on a 1/1 ARM may be anywhere from 0% to 2% lower than that of a fixed rate loan. Almost all ARMs mitigate the buyer’s risk of increasing interest rates by placing caps on how much interest rates can go up (or down) during each adjustment period and how much they can increase (or decrease) over the life of the loan. This allows the borrower to anticipate the worst case scenario in possible monthly payment increases.
These common interest rate structures can be modified to produce two variants that are used primarily in high interest rate markets or as a means of qualifying buyers for properties that they otherwise couldn’t afford.
Balloon Mortgages. As with an ARM, rates on balloon mortgages are lower than rates on fixed mortgages because the borrower is sharing risks of long term interest rate changes with the investor. Payments on a balloon mortgage are generally calculated as if the loan was for a 30 year fixed term, but the loan actually has to be paid off or refinanced (with a large “balloon payment”) at the end of an initial 5, 7 or 10 year term. Generally, the lender will guarantee to refinance the loan at the end of the initial term, but at the market rates prevailing at that time.
Buy Down Mortgages. A “buy down” is generally a fixed rate mortgage for which someone (the seller, the buyer or the lender) has made an initial cash payment that reduces the buyer’s monthly payment for the first 2-3 years of the loan term. This may be attractive to buyers who anticipate an increase in income within a year or two. They are also offered by many home builders since they increase the number of buyers who can qualify to purchase their homes.
Because of the risk of increasing interest rates associated with ARM loans, many buyers don’t give them serious consideration. But there are some good reasons that 20% of American (and 80% of British) homeowners choose ARMs. Consider:
Because they offer lower interest rates, ARMs allow some homeowners to buy when or where they otherwise could not. With increasing prices in many real estate markets, it can make sense to purchase with an ARM loan rather than waiting to qualify for a fixed rate loan only to find that increasing prices have locked you out of the market.
If the buyer is planning on selling a property with just a few years, or if they are planning on paying off or refinancing the loan, it makes little sense to take a fixed rate loan with an interest rate that is a point or two higher than an ARM.
If interest rate differentials between ARMs and fixed rate mortgages are very high, smart, disciplined buyers can use ARMs to their advantage. For example, at an initial interest rate of 4%, the payment on the 30 year $200,000 loan used in our example above would be about $950, compared to $1200 at a 6% fixed rate. By paying that same $1200 monthly on the 4% ARM, the borrower pays an extra $250 per month to principle, that is, about $450 a month rather than $200 a month. This $450 is almost 38% of the monthly payment, just short of the 41% we calculated for the 15 year loan. Assuming interest rates don’t increase, the buyers making $1200 payments on the 4% ARM will pay off their loan about 10 years earlier than the buyers making the same payment on the fixed rate mortgage.