Shopping for a Mortgage?
DO
YOUR
HOMEWORK
FIRST
Traditional Mortgages:
Understanding
Your Options
UNDERSTANDING TRADITIONAL MORTGAGES
When shopping for a mortgage, consumers have more choices than ever
before. Many lenders now offer specialty mortgages
that help make homeownership more affordable but have risks that
consumers should fully consider (see our brochure on
specialty mortgages). But for most consumers, the traditional
fixed-rate mortgage and adjustable-rate mortgage (ARM)
continue to be excellent options. However, even these traditional
financing options require a number of important
decisions. Should you get a 15- or 30-year loan? Should you get a
fixed-rate mortgage to lock in today’s interest rates for
the term of the loan—or take an adjustable-rate loan with a lower
current rate and payment, but with the risk of rate
and payment increases in the years ahead?
You can also tap the equity in your home by refinancing your
existing mortgage, taking out a second mortgage, or obtaining
a home equity line of credit. This brochure helps you consider these
options as well.
We hope this article will help you understand traditional mortgages
and make the choice that is best for you.
Fixed-Rate Mortgages:
With a fixed-rate mortgage, you are guaranteed the same interest
rate over the life of the loan.
Your monthly payments never change, and the loan is paid off
completely over the term you select.
The key choice involves how long you have to pay back the loan. The
most common options are 15- and 30-year loans,
with the 30-year being the most popular. As this chart illustrates,
a shorter-term loan comes with both a lower interest
rate and higher monthly payments (so that you pay the loan back
faster). Rates, and the differences between rates for
15- and 30-year loans, change daily.
Adjustable-Rate Mortgages:
The initial interest rate on an adjustable-rate mortgage (ARM) is
generally lower than that
for a fixed-rate loan. However, with an ARM, the interest rate may
increase or decrease in the future, and the sizeof your payments will go up or down along with the rate.
Most ARMs are “hybrids,” meaning that the interest rate is “fixed”
for a certain number of years—after which the rate
begins to “float.” The most common ARMs fix the initial rate for
three, five, or seven years. ARMs are probably most
appropriate for people who have sufficient financial resources to
handle potential payment increases or know that they
plan to sell their home around the time the loan’s interest rate is
set to change.
Important Features of Adjustable-Rate Loans:
Before agreeing to an ARM, you should ask the following questions:
•
How long does the initial interest rate apply?
•
How frequently can the interest rate change?
•
How is the adjusted interest rate determined?
(Generally, a specified amount—the “margin”—is added to a current
published rate—the “index.”)
•
How high can the interest rate go?
•
Does the loan set a minimum interest rate?
•
Are there any limits on how much the interest rate can change each
year?
•
Do the monthly payments still pay off the loan even if interest
rates increase? (With some loans, the amount you still owe—your “loan balance”—can increase rather than
decrease each month. This is called negative amortization.)
•
What is the maximum monthly payment that you could be required to
pay?
Potential Pitfalls of ARMs:
Even small changes in your interest rate can increase your monthly
payment significantly,
resulting in “payment shock.” Even a change of 1% or 2% in interest
rates can result in a very big jump
in your monthly mortgage payment. For example, if the interest rate
on your mortgage changes from 4% to 6%,
your monthly payment could rise by as much as 50% (from $1,000 to
$1,500).
ARMs can be complicated, and many specialty ARMs (with risky terms
appropriate only for a small group of borrowers)
are now being marketed widely. Be sure to avoid loans with terms
that you don’t understand. Get a copy of our
brochure on “Specialty Mortgages: What Are the Risks and
Advantages?” to learn more about these ARMs.
UNDERSTANDING HOME EQUITY
People who have paid down their mortgage or seen their home’s value
rise have equity in their home. Equity is the
difference between the home’s value and what you owe the mortgage
lender. One benefit of homeownership is the
ability to build equity. Homeowners draw on equity for emergencies
and for retirement income. Equity also allows
you to pass wealth (the home or the money made by selling that home)
from one generation to the next.
Refinance Loans:
In recent years, many people have refinanced their home loans to
take advantage of low interest
rates. Some have also refinanced in order to obtain cash. In a
refinance, you pay off your mortgage with a new loan.
In a “cash-out refinance,” you increase the size of your debt in
order to get cash at the closing table that you can
use for other purposes.
In any refinance, it’s important to ask about the fees you will pay.
Sometimes, even substantial fees are easily hidden,
as lenders may roll the fees into the loan balance. Of course,
increasing the loan balance
decreases
your home equity.
BORROWING
AGAINST YOUR EQUITY
Many people borrow against their equity. Two options for doing this
are a traditional second mortgage and a home
equity line of credit.
With both methods, you use your house as collateral— which means
that you risk losing your home if you can’t
repay the loan according to its terms. The lender decides how much
money to make available by considering, in
part, how much of the mortgage debt you still owe.
Traditional Second Mortgage Loans:
A second mortgage provides a predetermined amount of money that the
homeowner is obligated to repay over a fixed period. Second
mortgages generally come with fixed interest rates.
Home Equity Lines of Credit:
A home equity line of credit (HELOC) is a form of revolving credit.
Generally,
you can borrow up to a certain amount (the “credit limit”) over a
predetermined period of time (the “draw period”).
The repayment terms of HELOCs vary. For example, many HELOCs are
structured so that monthly payments cover
only interest for the first ten years.
A HELOC generally carries a variable rate. If you consider a HELOC,
you should ask the same questions about how
this rate is set (and may change over time) that you would ask when
considering any other adjustable-rate mortgage.
If you sell your home, you will have to pay off or refinance your
HELOC.
|
|
15-Year |
30-Year |
|
Interest rate |
5.5% |
6% |
|
Amount financed |
$200,000 |
$200,000 |
|
Monthly payment |
$1,634 |
$1,199 |
|
Loan balance after 5 years |
$150,578 |
$186,109 |
|
Loan balance after 10 years |
$85,553 |
$167,371 |
HELPFUL
STEPS TO TAKE BEFORE
BUYING A HOME
•
Check your credit status.
You have the right to receive a free credit report once a year from
each of the three
major credit bureaus—Equifax, Experian, and TransUnion. For
completeness, it is best to review the report from
each one of them. Contact information is included under
“Additional Resources.”
•
Work with your REALTOR®
and lender to determine how much you can afford to pay for a home.
•
Ask your lender for your credit score.
This score, which is calculated based on your credit history and
other factors, determines how lenders view your creditworthiness
and the loan terms they offer. Scoring rules
vary widely, but generally a score of 650 or higher means that you
qualify for the most favorable loan terms.
•
Shop around.
Different lenders charge different rates and fees and have different
options. Be sure to compare to get the best deal.
•
Be sure you understand the risks of your mortgage and know whether
you can handle possible payment increases.
WHAT YOU
SHOULD KNOW ABOUT PREDATORY
LENDING
“Predatory lending” refers to a variety of lending practices that
strip wealth from borrowers. High fees and excessive
prepayment penalties are hallmarks of predatory loans. Fees are
costs to borrowers that are not directly reflected
in interest rates. On competitive loans, fees below 1% of the loan
amount are typical. On predatory loans, fees
totaling more than 5% of the loan amount are common. A prepayment
penalty is a fee charged by a lender when
a borrower pays off a mortgage before all the payments are due. This
“early pay-off ” can happen because you
move or refinance your mortgage to get a lower, more affordable
interest rate. While uncommon in the prime
mortgage market, these penalties are included in up to 80% of
subprime mortgages—those loans designed
mainly for borrowers with flawed or incomplete credit histories.
It’s wise to ask whether a loan has a prepayment
penalty, how long it will remain in effect, how much it would cost
to pay off the loan early, and whether
there are circumstances under which the penalty would be waived.
This information provided Courtesy of:
National Association of REALTORS®
500 New Jersey Avenue, NW
Washington, DC 20001
Center for Responsible Lending
910 17th Street NW, Suite 500
Washington, DC 20006
Return to Article
Archive
| 
Member, National Association of Realtors
®
