Buying a home: Mortgage 101

April 20th, 2012 Jamie Allison
saving for a down payment

Editors Note – this article is the third article in our series “Buying a home.”  In this series we’ll share tips and tricks that will help make the home buying process less confusing and more enjoyable.

Selecting a mortgage can be confusing, frustrating and time-consuming. Nonetheless, picking a mortgage may be the most important financial decision you will make.

Mortgage lenders offer a variety of loans under different names with different interest rates, up-front costs, and fine print terms. Take your time to learn about all your options to ensure you receive a mortgage that best fits your needs at a competitive price.

What is a mortgage?

Likely the largest debt you’ll ever take on, a mortgage is a loan to finance the purchase of your home.

Your mortgage consists of a “life” of the mortgage and a “term” for the interest rate that you choose. The life of the home mortgage is commonly 15, 20, or 30 years. This represents the length of time in which your home will be paid off (if you pay regularly and with the specified amount).

You will also have a term for the interest rate that you pay on your home mortgage. In effect, this is the time period over which you’ve agreed to pay at a particular rate of home mortgage interest (either locked in or floating).

There are many different types of mortgages available on the market, including, fixed rate, adjustable rate, combination, graduated payment, and others.

Fixed rate mortgages

The fixed rate mortgage (FRM) is considered by many as the “traditional” mortgage. Its advantage is that neither the interest rate nor the monthly payment (principal and interest) changes over the life of the loan.

There are two main types of fixed rate mortgages:

  • 30 Year Fixed Rate Mortgages and
  • 15 Year Fixed Rate Mortgages

Other terms (such as 10 or 20 Year Fixed Rate Mortgages) exist but they are not as commonly used.

The beauty of fixed rate mortgages is that they allow you to predict what your loan payments will be in the future. No matter what happens with interest rates, your payments won’t change. Because these are fixed payments over a long period of time, the interest rate may be a bit higher.

Adjustable rate mortgage

If you plan to move or refinance in 3 to 5 years, an adjustable rate mortgage (ARM) might be the better choice for you. With an ARM, the interest rate can – and probably will – change periodically during the life of the loan, depending on interest rates in financial markets. It’s a trade-off. You get a lower rate with an ARM in exchange for assuming more risk.

You should review how long you intend on living in this particular property and weigh the advantage of the lower payment at the beginning of the loan against the risk that an increase in interest rates would lead to higher monthly payments in the future, assuming you still own the property.

With most ARMs, the interest rate and monthly payment are fixed for an initial time period such as 1 year, 3 years, 5 years, 7 years or 10 years. After the initial fixed period, the interest rate can change every year. One of the most popular mortgages is 5/1 ARM. The interest rate will remain fixed, at the initial rate for the first 5 years, but has the ability to change every year after the first 5 years.

Most ARM interest rate changes are tied to changes in an index rate. This provides you with assurance that rate adjustments will be based on actual market conditions at the time of the adjustment. If the index rate rises, your mortgage interest rate may as well, and you will probably have to make a higher monthly payment. On the other hand, if the index rate goes down your monthly payment may decrease.

One feature of ARM that can help protect the borrower is interest rate caps.

An interest-rate cap places a limit on the amount your interest rate can increase or decrease, at any adjustment period. As you can imagine, interest rate caps are very important since no one can predict what will happen in the future.

While there are numerous mortgage products available these are two of the most common ones. Don’t hesitate to work closely with your loan officer to learn about all your options.

Jamie Allison

About the author

Jamie Allison is a Real Estate Loan Officer with MidWestOne Bank. He helps customers navigate the home buying process and achieve the dream of home ownership.

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