If you have an “impound account” your monthly payments may vary despite having a fixed rate mortgage. Besides the monthly loan payments some lenders collect extra money each month for those who put down less than 20% on his or her home. This money is used to make up the different of property taxes and homeowners insurance. The money is put in an impound account and used to pay the borrower’s property taxes and insurance premium when due. If the amount of tax or insurance changes then the monthly payment will change. Generally the overall payments for a fixed rate mortgage stay the same and will not change much.

Adjustable Rate Mortgages (ARM)
An adjustable rate mortgage is a loan that has an interest rate that may fluctuate during the loan’s term. These loans normally start with a fixed rate for a designated period of time, and at the end of that term the rate is adjusted based on the current market. Generally the initial rate is lower than a fixed rate mortgage so you can afford a more expensive home. ARM loans are amortized over 30 years with the fixed interest lasting anywhere from one month to ten years. Two components of adjustable rate mortgages is the “margin” plus “index.” Margins on loans can be anywhere between 1.75 and 3.5 percent varying based on the index and amount financed in relation to the value of the property. The index is tied to: 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI).

The index is a financial instrument the ARM loan is connected to. An example of this is when it is time to adjust the ARM, the margin will be added to the index and rounded to the nearest 1/8 percent to generate the new interest rate. For that entire adjustment period, this figure with is the new rate. How often this is adjusted can vary, but it is typically done every year. There are factors, or caps, that limit how much the rates can fluctuate. If you had a “3/1 ARM” with a cap of 2 percent, a lifetime cap of 6 percent and an initial interest rate of 6.25 percent, the highest rate possible for the fourth year is 8.25 percent. The highest rate you can have in the entire life of the loan is 12.25 percent.

For a minimal charge some ARM loans have a feature that allows you to convert the loan from an adjustable rate to a fixed rate. The conversion rate is often slightly higher than the market rate a lender could give you at the time of refinancing.

Hybrid ARMs (3/1 ARM, 5/1 ARM, 7/1 ARM, 10/1 ARM)
Hybrid ARM mortgages, also know as fixed-period ARMS, have both features of fixed-rate and adjustable mortgages. At first a hybrid loan has an interest rate that is fixed for 3,5,7 or 10 years. After this time period, the loan changes to an ARM for a set amount of years. For example, a 30-year hybrid would have a fixed rate for five years and an adjustable rate for 25 years.

The nice thing about a hybrid is the initial interest rate for the fixed years is generally lower than the rate of a mortgage that is fixed for 30 years. This means you can have a low rate with stable payments. Typically a one-year ARM changes rates every year after the first 12 months of the loan. Although the starting rate of an ARM is extremely lower than a standard mortgage, it is very likely the price will spike in the future.

When homeowners receive hybrid loans, it is possible to refinance when the initial term expires. If people do not plan to live in their homes for a long period of time, hybrid loans are the choice to make. A lower rate allows for lower monthly payment with a 30- or 15-year loan. Because the monthly payments are lower, borrowers have more money to make extra payments and pay the loan off sooner. This saves the borrower thousands of dollars.

Interest Only Mortgages
A loan that is “Interest Only” means that the monthly payment does not include repayment of the principal for a set amount of time. This type of mortgage is available with fixed rate or adjustable rate loans. Once the interest only period ends, the loan is then fully amortized and payments greatly increase. The payment is larger than what it would have been if amortized from the beginning of the loan. The more time the loan is interest only, the larger the payment will be at the end of the period. During the interest only term equity is not built, but it may help you get a home you want instead of settling for the home you have money for.

Most likely, because you are qualified based on the interest only payment, you will be able to refinance before the period ends. This way you can lease your dream home while investing the principal portion somewhere else. This allows you to enjoy the tax advantages that come with owning a home.

For example, if $250,000 is borrowed at 6 percent with a 30-year fixed-rate mortgage, the monthly payment is $1,499. At the same time, if $250,000 was borrowed at 6 percent with a 30-year mortgage having a 5-year interest only period, the monthly payment is $1,250. Every month you would save $249 or $2,987 a year. When year six is reached, the monthly payment will jump to $1,611 or $361 more a month. Ideally, you want your income to increase as well to be able to afford higher payments, or you can refinance to lower payments.

Over a 30-year time period, mortgages with interest only options will cost more than other loans. In the short term it does seem like you are saving money. It is important to keep in mind that most borrowers pay the loan in full before the end of the 30-year loan term.

Those who have inconsistent incomes fine the interest only mortgages most beneficial. When incomes are sporadic it is easier to pay just the interest in lean times and when extra money is available borrowers can pay down part of the principal.

Components of Adjustable Rate Mortgages

In order to fully understand an ARM it important to have full knowledge of the following components:

Index: A financial gauge that increases and decreases based on fluctuations in the economy. It is then a basis for all future interest adjustments on the mortgage.

Margin: The margin is the cost of the loan plus profit. It is added to the index to decide the complete interest rate. The index is the cost of funds and the margin is the lender’s cost of business including profit.

Initial Interest: This is the beginning rate of the loan. Generally the initial interest is much lower than the note rate. It can be almost a “teaser rate” to draw people in to buy the loan.

Note Rate: The interest rate chard for the loan.

Adjustment Period: The time that interest changes during the life of the loan. An example of this is the interest rate change annually.

Interest Rate Caps: The most or least change an interest rate can make. The caps are specific and set time periods for adjustment and lifetime adjustment. An example would be a cap of 4 and 6 means 4% interest increase maximum per adjustments with 6% interest increase maximum over the life of the loan.

Negative Amortization: When a payment is not big enough to cover the interest of a loan, the shorted amount is added back onto the principal balance.

Convertibility: The ability to change from an ARM to a fixed-rate mortgage. This may come at a fee.

Carryover: Although not applicable to most newer ARMS, this means the interest rate increases past the maximum amount allowed by caps. This can be later applied to interest rate adjustments.

Commonly Used Indexes for ARMs

6-Month CD Rate
This is an index that is the weekly average of a 6-month negotiable Certificate of Deposit based on secondary market interest rates. The interest rate of a 6-month CD indexed ARM loan is generally adjusted every six months. Indexes are volatile and can change weekly.

1-year T-Bill
Used for a majority of ARM loans, the index is a weekly average yield on U.S. Treasury securities adjusted to a constant maturity of 1 year. When used with a traditional one-year loan the interest changes once each year. There are other ARM loan programs out there for those who want to take advantage of a low rate but would like a longer introductory period. The 3/1, 5/1, 7/1 and 10/1 ARM loans offer a fixed interest rate for a specified time, generally 3,5,7 or 10 years, before yearly adjustments begin. The rates aer lower than a 30-year fixed mortgage, but generally do not have introductory rates as low as the one year ARM loan. The index is sometimes volatile because it changes on a weekly basis.

3-year T-Note
A weekly average yield on the U.S. Treasury that is adjusted to a constant maturity for three years is a 3-year T-Note. This index is used on 3/3 ARM loans. The interest rate on these loans is adjusted every three years. Those who like fewer interest rate adjustments would be interested in this type of loan program. The changes are volatile and occur weekly.

5-year T-Note
A weekly average yield on the U.S. Treasury that is adjusted to a constant maturity for three years is a 5-year T-Note. This index is used on 3/3 ARM loans. The interest rate on these loans is adjusted every five years. Those who like fewer interest rate adjustments would be interested in this type of loan program. The changes are volatile and occur weekly.

Prime
The prime rate is the interest rate banks charge the most credit-worthy customers. Most large banks charge the prime rate that is reported by the Federal Reserve. If applying for a loan be sure to ask if the prime rate applies to only that bank or is published by the Federal Reserve or the Wall Street Journal. Often this index changes based on economic conditions, it can be volatile or not change for a long period of time.

12 Moving Average of 1-year T-Bill
Adjusted to a constant maturity for one year, twelve month moving average of the average monthly yield on U.S. Treasury securities. This index is sometimes used for ARM loans in lieu of the 1 year TCM rate. Because the index is a 12 month movie average it changes less frequently than the one year TCM rate. This index is not volatile and changes on a monthly basis.

Cost of Funds Index (COFI) – National
This Index is the monthly median cost of funds: interest (dividends) paid or accrued on deposits, FHLB (Federal Home Loan Bank) advances and on other borrowed money during a month as a percent of balances of deposits and borrowings at month end. These COFI rates are generally adjusted every 6 months. The index is not very volatile and changes on a monthly basis.

Cost of Funds Index (COFI) – 11th District
The COFI index is an average interest rate paid by the 11th Federal Home Loan Bank District savings institutions for savings and checking accounts, advances from the FHLB, and other sources of funds. The 11th Federal Home Loan Bank District includes the savings institutions in Arizona, California and Nevada. Most interest is paid on savings accounts, so this index lags market interests rates in downtrend and uptrend movements. ARMs related to this rise and fall slower than rates in general.

LIBOR
L.I.B.O.R stands for the London Interbank Offered Rate, the interest rates that banks charge each other for overseas deposits of U.S. dollars. L.I.B.O.R. exist in 1,3,6 and 12 month terms. The index used and the source of the index will vary by lender. Many rates are based off the Wall Street Journal and Fannie Mae. The rates are adjusted every six months and can change daily or weekly causing them to be extremely volatile.

National Average Contract Mortgage Rate (NACR)
This index is the national average contract mortgage for previously owned homes. Combined lenders determine the rate; it changes monthly and is not volatile.

Balloon Mortgages
Balloon Mortgages have a fixed note rate for a certain amount of time, after that the remaining principal balance is due at the end of the term. When that point comes, the borrower can refinance or pay off the balance. There are no penalties for paying off the loan before it is due and you can refinance at any point during the loan’s term. A balloon loan is generally five or seven years. This means if you have a balloon mortgage for 5 years and your interest rate is 7.5%, your rate is that for the entire term, but then after five years the rest of the principal is due.

Reverse Mortgages
A reverse mortgage is a home equity loan that enables you to convert some of your equity into cash while you still own your home. It is like a traditional mortgage, but opposite. Instead of you making payments to the bank every month, you are paid instead. There is no repayment of principal, interest or fees as long as you live in the home. The money can be used for any purpose.

In order to receive a reverse mortgage, you have to own your house. The money may be given to you at one time, in monthly advances or by a line of credit. Sometimes the loan is dispensed in all three methods. The amount you will receive is based off your age, how much your home is worth and the interest the lender is charging.

Although the bank is giving you equity on your home with a reverse mortgage, you must keep up on the house tax, repairs and maintenance. Depending on the loan requirements, the reverse mortgage may be due with interest when you move, sell your home, die or reach the end of the loan term. If you pass away, the bank does not take the title of the home, but the heirs must pay the loan off in entirety.

Graduated Payment Mortgages
A graduated payment mortgage is when a loan payment increases annually for a certain time period, usually five or ten years. After this time period it becomes fixed for the rest of the loan. During the high interest points, borrowers use them as a leverage to be able to more readily qualify because the initial payment is less. Although the initial payment is less the interest is not less. The payment shortfall is added back on the principal of the loan, this may end in negative amortization.

What kind of loan program is best for you?
It’s hard to decide what mortgage is best to suit your personal needs. There is no definite answer what is best, and given so many types of loans and the circumstances with each one it is hard to decide. This is one of the most important choices you will make so it is important to take time to consider each option. Be sure to put in lengthy research and talk to consultants before signing any documents. Making the right decision may save you thousands of dollars in the end. Ask yourself these questions to help you narrow your search down to decide what loan truly is best for you:

* Do you expect your finances to change over the next few years?
* Are you planning to live in this home for a long period of time?
* Are you comfortable with the idea of a changing mortgage payment amount?
* Do you wish to be free of mortgage debt as your children approach college age or as you prepare for retirement?

Lenders can help you narrow the questions further to find the perfect loan for you. Here is a guideline that may be useful to consider when choosing the mortgage for your new home:

Years you plan to stay in your home Plan to Consider

1-3 3/1 ARM or 1-year ARM

3-5 5/1 ARM

5-7 7/1 ARM

7-10 10/1 ARM or 30-year fixed

10+ 30-year fixed or 15-year fixed