Finance Types

While we offer several finance methods, most finance methods  contain different features that can be confusing for even experienced homeowners. The most common finance methods include:

Fixed Rate Mortgages

The interest rate on a Fixed Rate Mortgage remains fixed for the life of the loan and monthly payments of principal and interest payments never change.

The most common fixed rate terms include the 30-year term and 15-year term. In general, the shorter the term, the lower the interest rate and the higher the principal and interest payment. Therefore, the interest rate on a 15-year term loan is lower than the rate of a 30-year term loan, however, the principal and interest payment on a 15-year term is higher than the payment on a 30-year term.

Distinction between 15-year fixed term and 30-year fixed term

  • Interest rates for a 15-year term are slightly lower than rates for a 30-year term.
  • Interest costs are significantly reduced for a 15-year term due to lower interest rate and shorter loan term. Equity builds faster in a 15-year term than in a 30-year term.
  • Principal is paid down quicker in a 15-year term resulting in faster equity growth.
  • Monthly principal and interest payments are higher in the 15-year term, and as a result, your qualifying loan amount will be less than a 30-year term.

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Balloons are short-term mortgages that contain features similar to fixed rate mortgages. Typically, the Balloon is a short-term loan, however, the monthly payments are calculated using a 30-year term. Such payments remain unchanged for a predetermined period, at the end of which, a lump sum payment is due to pay off the remaining principal balance of the loan. This larger payment is the “balloon” payment.

In general, borrowers sell or refinance before their balloons are due. Most balloon loan programs offer options to convert to a fixed rate at the end of the loan term. For example, a 7/23 balloon mortgage gives the borrower the option to convert to a fixed rate program (for a nominal fee) after the initial term (7 years) is over. If the conversion feature is used, the interest rate for the remaining term of the loan (23 years) will be adjusted once to reflect market conditions, then remain fixed for the remainder of the loan term. To qualify for the option, the borrower must typically still be an owner-occupant, have no previous late payments, and have no liens against the property. Other conditions may apply.

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Adjustable Rate Mortgages

Adjustable-rate mortgages (ARMs) became popular in the early 1980s when interest rates were much higher. When lenders were offering fixed rate mortgages at 15 percent to 16 percent, over 60 percent of homebuyers chose ARMs with interest rates starting at 12 percent to 13 percent. Currently with low fixed rates, most lenders reported that fewer than 15 percent of homebuyers were financing their homes with ARMs.

ARMs are good to consider when:

  • You believe that rates are going to fall to levels much lower than they are today.
  • You only plan to keep your home for two or three years, and an ARM looks less expensive in the short term.

Graph 1

The obvious difference between an adjustable rate mortgage and a traditional fixed rate mortgage is that with an ARM, the interest rate goes up and down. It changes according to a set of formula (typically one year) for the life of the loan. Usually, your monthly payment goes up and down with the interest rate.

An ARM, much like a new home, has some basic features and a number of options.

Basic Features
Adjustable Interval
Initial Interest Rate

Optional Features
Periodic Interest Rate Cap
Life Interest Rate Cap
Initial Adjustment Rate Cap
Fixed rate conversion option

Graph 2

An ARM's interest rate goes up and down according to a nationally published index. Your lender has no control over the index and cannot arbitrarily adjust your rate. Your rate is determined by the index.

Different ARMs have different indexes. The One-Year Treasury Bond Index is the most common ARM index. Other indexes are:

  • Six-Month Treasury Bill
  • Three-Year Treasury Bond Index
  • Five-Year Treasury Bond Index
  • 11th District Cost of Funds Index - COFI
  • London InterBank Offered Rate - LIBOR
  • Prime Rate

Graph 3

Your ARM's interest rate is the sum of the index value plus the margin. Your lender sets the ARM's margin before settlement of your loan. Once set, the margin does not change for the life of the loan. In a hypothetical example if the margin is set at 2.75 percent and the index is 4.75 percent, the rate for the following year becomes 7.50 percent (2.75 percent plus 4.75 percent).

Adjustment Interval
The interest rate of an ARM changes at fixed intervals. This is called the adjustment interval. Different ARMs have different adjustment intervals. The interest rate of most ARMs adjust once a year, but others adjust every month, every six months, every three years or every five years. An ARM whose rate changes once a year is called a "one-year ARM". The graphed example is a one-year ARM.

Graph 4

Sometimes the first adjustment interval is longer or shorter than the following intervals. For instance, an ARM's interest rate might not change for the first three years, and then change once a year thereafter. Or the initial rate might change after ten months rather than a year.

Initial Interest Rate
The final feature common though all adjustable rate mortgages is the initial interest rate. This is the rate that you pay until the end of the first adjustment interval. The initial interest rate also determines the size of your starting monthly payment. The initial interest rate for most ARM's is lower than standard fixed rates.

Graph 5

Often the initial interest rate is lower than the sum of the current index value plus margin. When it is several percentage points lower, it is called a teaser rate. If your ARM starts with a teaser rate, your interest rate and monthly payment will increase at the end of the first adjustment interval unless your ARM's index goes down.

Optional Features
Most ARMs have consumer protection options that limit the amount that your interest rate and monthly payment can increase. They are called caps.

Periodic Interest Rate Cap
The first type of cap is the periodic interest rate cap. It limits the amount an ARM's interest rate can change from one adjustment interval to the next. If the periodic interest rate cap is two percent, this means that the ARM's interest rate cannot go up more than two percent. Without a periodic interest rate cap, the ARM's rate could exceed that amount if the index moves more than the amount of the periodic interest rate cap.

Graph 7

Life Interest Rate Cap
The second type of cap that you want on an ARM is the life interest rate cap. It sets the maximum interest rate that you can be charged for the life of the loan. If the life interest rate cap is 12 percent and the index value plus margin equals 13 percent, the life cap would limit the rate increase to 12 percent. Even if the index went to 16 percent, as the One-Year Treasury Bond Index did in 1982, the interest rate of this ARM would still be limited to 12 percent.

Typically the life cap is quoted as percentage points over the initial interest rate (i.e., a "six percent life interest rate cap" means five percent over the initial rate).

Graph 6

Initial Adjustment Rate Cap
If an ARM has an initial fixed period of more than one year a lender may provide that the first adjustment exceed the periodic interest rate cap. This means the initial adjustment could raise your interest rate and payment substantially, but never more than the life interest rate cap.

Conversion Option
This provides the borrower with the opportunity to convert their ARM rate to a fixed rate during a specified time period. Typically, the borrower must have had the loan for the fixed period of the loan plus one or more years. The conversion option also provides for the fees to be paid and a rate formula to determine what the new fixed rate will be. That rate may be higher than fixed rates available by refinancing but it may eliminate other closing costs encountered with a refinance.

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