There are a number of OPTIONS in selecting a loan product that best suits your specific real estate transaction, including FHA, VA, Conventional and Jumbo. Within these products there are two primary loan types: Fixed Rate Mortgages and Adjustable Rate Mortgages.
There are simple tests to help determine which of the two basic loan types is right for you.
- If your ownership of the property to be financed is long-term (10 or more years) a fixed rate loan is likely in your best interests.
- If your ownership of the property is shorter term, like 3 to ten years, there may be a very appealing ARM loan that has an extended initial rate term of 5, 7 or even 10 years.
It is important to consider that intentions can change mid-stream, which can also change the wisdom of your original choice. If you intend to own the property for 5 years, try to select a loan that gives you a little wiggle room for your personal security…like selecting an ARM with a 7 year initial rate.
FIXED RATE MORTGAGE
This is the pure and simple “no surprises” home mortgage. Fixed-Rate Mortgage payments remain constant throughout the life of the loan. The interest rate and other terms are fixed and do not change. The only thing you need to consider, other than the interest rate, is the term. The shorter the term, the higher the payment (faster principal payoff). The most common terms are 15 and 30 years.
- Consistent interest rate and monthly payments. Payments may change based on escrow changes for property taxes and insurance.
- Choice of term options, including 10, 15, 20, 25, and 30-year options.
- A good choice for people who will own their home long-term.
- A good choice for people who want to minimize risk.
- May not be a good choice when expected time of home ownership is short.
- Higher rate compared to Adjustable Rate Mortgage, because the lender guarantees the rate longer.
- May not be a good choice for clients with a tolerance for risk, who believe rates will be lower in the future.
ADJUSTABLE RATE MORTGAGE (ARM)
An Adjustable Rate Mortgage is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices. Among the most common indices, are the 1-year Constant Maturity Treasury (CMT) and the London Interbank Offered Rate (LIBOR). To determine if an Adjustable Rate Mortgage is right for you, consider the pros and cons:
- Lower initial interest rate and monthly payments.
- Best used when borrower plans a short-term of ownership (3 to 7 years).
- Borrowers with a higher tolerance for risk often choose this option when they have reason to believe rates will be lower in the near term, and they intend to refinance at that time.
- May also be used as a strategy to provide a lower payment while waiting for an imminent promotion or scheduled raise, to facilitate buying a more expensive home earlier.
- Interest rate can increase over time.
- Not the best fit for borrowers who expect to remain in the home long-term.
The most important basic features of ARMs are:
- Initial interest rate. This is the beginning interest rate on an ARM.
- The adjustment period. This identifies the initial length of time that the interest rate on an ARM is scheduled to remain unchanged. It also dictates how often the rate will reset at the end of this period. Each time the rate changes –up or down- and the monthly loan payment changes with it.
- The index rate. ARM interest rates are tied to a specific, published index rate. There are a variety of preferred indices, the most common being rates on US Treasury securities, Prime Rate and LIBOR. The index is the controlling mechanism of which direction the interest rate on your ARM loan will adjust at the next change date.
- The margin. This is the percentage (in points) that lenders add to the index rate to determine the ARM loan’s interest rate.
- Interest rate caps. These set limits on the amount your interest rate can chang per adjustment period as well as the highest the interest is permitted to increase over the start rate for the life of the loan.
Here are a couple common Cap examples:
- 5/2/5 (Initial/Periodic/Lifetime) The Initial rate change is cannot exceed 5% over the start rate, each change after the initial period can change no more than 2%, as long as the rate never exceeds 5% over the Start Rate. 2/6 (Initial/Lifetime) The Initial Rate change and every subsequent change cannot exceed 2% of the then current rate. Lifetime, the interest rate can never be higher that 6% above the Start Rate.
The selection process for FHA, VA, Conventional and Jumbo loans is also very simple, often predicated on “if – then” scenarios.
FHA Home Loan: Low down payment, moderately priced home, more forgiving approval standards.
VA Home Loan: Veterans only. Non-veterans need not even bother reading about them. Often a VA loan is the best loan in terms of lowest cash requirement, easy approval standards and lowest cost (interest rate and closing costs). VA Loans are available in a very wide size range reaching into the jumbo category with a modest down payment.
Conventional Home Loan: Low to moderate loan amounts and down payments, but while they generally compare favorably to FHA in pricing (interest rate and costs), additional fees can quickly accumulate for borrowers with flawed credit. Approval standards are tougher than FHA and VA.
Jumbo Home Loan: Higher balance loans, anything exceeding the Fannie Mae and Freddie Mac loan size limits. These loans carry higher interest rates than conventional loans. The approval standards mirror conventional loans in most cases, but each jumbo lender may inject their own particular criteria in addition to using the standard Fannie Mae & Freddie Mac guidelines. If you qualify for a VA loan, don’t overlook the likelihood that a VA Jumbo loan will outshine a standard jumbo loan.