Understanding Mortgage Loan Terms

The understanding of mortgage loan terms, how the term affects the home buyers monthly mortgage payment, and how it impacts the total cost the home buyer will pay for their home over the life of the mortgage loan is of utmost importance.

There are literally hundreds of types of mortgages available, but almost all of them fit into two major categories: the fixed-rate or adjustable-rate mortgage loan. 

Fixed-Rate Mortgage

Fixed-rate mortgages are desirable because the interest rate does not change and the monthly principal and interest amounts are “fixed” over the life of the loan. Typical fixed-rate loans are made for 30, 20 or 15 years, although other timeframes are available from many lenders.

Adjustable-Rate Mortgage

The terms of an adjustable-rate mortgage (ARM) allow the interest rate to fluctuate up or down (usually up!) at specified times to reflect market conditions. An ARM can be adjusted up or down based on the latest interest rates. The amount you pay for principal and interest will change accordingly. Some ARMs are artificially low at the beginning of the loan, then automatically adjust higher in one or more years. “Interest-only” rates are another example of loans that start low and increase later on (in this case with all of the interest deferred to a later date). ARMs are usually best for people who don’t plan on living in a home for more than five to seven years.

Advantages of Fixed Mortgages

• Fixed monthly principal and interest payments for the life of the loan
• Interest rate does not change no matter what happens to the economy or how much interest rates change in the future because you are “locked in” to a specific “fixed” interest rate
• Borrowers can budget for all future expenses without worrying about changes in mortgage payments (although taxes and insurance can rise).

Disadvantages of Fixed Mortgages

• Fixed rate mortgages generally require higher income levels to qualify.
• If interest rates go down, you are locked into a higher rate, so you would need to refinance in order to get a more favorable rate.

Advantages of Adjustable Mortgages

• ARMs usually offer lower initial interest rates than fixed mortgages and therefore lower monthly payments.
• If interest rates go down, your payment will also decrease because your interest rate is tied to the current market rates.
• It is generally easier to qualify for an adjustable-rate mortgage because the initial interest rates and initial payments are generally lower than fixed rates, meaning that they will command less of your monthly income.
• If you know you will be staying in the home for a relatively short period of time (five years or less), an ARM may be the best option because the interest rate won’t adjust too high before you move.

Disadvantages of Adjustable Mortgages

• If market interest rates go up, your loan interest rate and monthly mortgage payments will increase accordingly.
• Spikes in inflation or dramatic increases in interest rates can price you out of your home because it can become too much to meet the higher monthly payments.

What Term is Best for You?

It is also wise to compare the terms of a 30-year fixed mortgage to a 15-year fixed mortgage. Although the monthly payments on a 15-year mortgage can be 20 percent to 25 percent higher per month than the monthly payments on a 30-year mortgage, you can pay off the loan in half the time, with a potential savings equal to about the same as the original loan amount than if you selected the longer term. (You would pay about $77,000 in interest on a $100,000 loan at 8.5 percent on a 15-year loan versus paying about $177,000 in interest on a $100,000 loan at 8.5 percent on a 30-year loan).

Loan experts suggest that most borrowers should aim for the shortest loan term they can afford, because the shorter the term the less you will pay in interest. At the beginning of a loan, up to 90 percent or more of the monthly payment goes to interest. As the term of the loan decreases, more of the monthly payment goes to principal, so that in the final years of a loan, most of the monthly payment is satisfying the outstanding principal.

If you find the monthly cost of a shorter-term loan too much to bear, you could still select a longer-term loan, but make extra payments each year above the usual 12 monthly payments (as long as your home loan does not impose pre-payment penalties).

Just one extra principal and interest payment per year (13 payments instead of 12) consistently from the advent of the loan and on through to the end could pay off a 30-year loan in less than 23 years.  That way you aren’t locked into making a higher mortgage payment each month, and you have the flexibility to pay off the loan at your own pace as your financial situation allows.

For more articles on mortgages, home financing, mortgage terms and interest rates, check out the mortgage category.  To prequalify for a mortgage, contact the home financing specialists at New Homes Central Lending Services.

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