Fixed rates vs. ARMs

There are many different types and variations of mortgage loans out there. One of the first decisions you will have to make about your potential mortgage loan is whether you want to obtain a fixed rate mortgage or an adjustable rate mortgage.

Fixed rate mortgage loans have constant interest rates that do not change for the life of the loan. In other words, if you start out with a 6% interest rate on your fixed rate mortgage, the interest rate will stay at 6% until the loan is paid off or you refinance the loan, regardless of fluctuating market interest rates.

An adjustable rate mortgage, on the other hand, features an interest rate that is fixed for a predetermined amount of time and then becomes an adjustable rate for the remainder of the loan term. Although adjustable rate mortgage products vary from lender to lender, the basics of these types of loans are usually very similar.

For example, a 5/1 ARM would be a loan that has a fixed rate for the first five years and then every year thereafter the loan would be subject to adjustment, based on whatever interest rate index the lender uses.

If this particular 5/1 ARM featured a 1% annual cap and a lifetime 5% cap that means that every year the interest rate would not raise or lower more than one percentage point, and over the entire life of the loan the rate would not go higher or lower than fiver percent of the original interest rate.

Although adjustable rate mortgages often have lower initial interest rates than fixed rate mortgages, there is always the potential for the interest rate to eventually become much higher. Fixed rate mortgages can offer a consistency that isn’t available with ARMs.

See our ARM vs. fixed rate mortgage calculator to see which option might be right for your financial situation.

ARMs explained

Adjustable rate mortgages (ARM) don’t involve a lot of definitions, but you will need to understand the numbers associated with them.

You will see numbers like 3/1, 5/1, and other combinations, and all of these are quite easy to understand once you become familiar with what each number represents.

In the case of ARM loans, the preceding number signifies how long the fixed rate lasts before the interest rate becomes variable. The second number represents how often the interest rate will fluctuate.

For example, a 3/1 ARM is a loan which has a fixed interest rate for the first three years of the loan and becomes a variable interest rate for the remainder of the amortization (typically 30 years). This loan will experience an interest rate adjustment once a year, which is what the “1″ represents.

How high or how low the interest rate can eventually climb or fall depends on the original mortgage terms and is signified by a numerical “cap.” If the 3/1 ARM has a 5 percent cap, this means that the interest rate can never go higher or lower than 5 percentage points of the original interest rate.

Prequalification vs. pre-approval

Part of the loan approval process for mortgage loans involve demonstrating to the seller that you can secure financing in the event that your proposed bid to purchase the home is accepted. Lenders offer two options for this, pre-qualification and pre-approval. While pre-qualification and pre-approvals are both useful, one is definitely superior to the other.

A pre-qualification is relatively easy to get. Most lenders will hand over a pre-qualification letter based solely on information the applicant gives, but without ever verifying any of the information.

Basically, a pre-qualification letter tells the seller that the lender would probably approve a loan for the applicant based on the information the applicant has supplied, but the information has not been verified at all and an application has not been approved.

On the other hand, a pre-approval letter is given only after an application has been submitted and tentatively approved pending approval of the home. This letter tells the seller that the lender has already approved the applicant and the funds will be available if the home appraises as it should.

It is far preferable to get a pre-approval letter before you even pick a home to buy because this can be the leg-up you need on the competition when putting in a bid to buy a home.

Home equity loans explained

Home equity loans are commonly advertised on television as being easily attainable and inexpensive. If you are unfamiliar with this type of loan, however, you may find yourself wondering what exactly it is and whether or not it is right for you.

The premise is actually quite simple. The equity in your home is the amount your home is worth minus any money owed on the home. An equity loan cashes in the available equity and uses your home as collateral for the loan. Home equity loans can be used for just about anything: Debt consolidation, home improvement projects, or perhaps even funding a vacation or other event.

Borrowers like home equity loans because the interest paid on the loan is sometimes tax deductible, and lenders like home equity loans because borrowers are statistically less likely to default if the loan is attached to their home.

The downside of this is that a default on a home equity loan can result in a foreclosure, even if the first mortgage is paid promptly. For this reason, a home equity loan is not something that should be utilized just because the money is there and is available.

Like all loans, home equity loans must be utilized wisely. The equity in your home should be seen as more of a safety net than as free money.

Home equity loan vs. line of credit

If you want to utilize the equity available in your home you have a couple of options: Home equity loans and home equity lines of credit. Most mortgage lenders offer both of these options.

A home equity loan is a loan that offers you one lump sum that is repaid on a monthly basis by the borrower. Home equity loans are often best for those who need a specific amount of money at one time.

A home equity line of credit is a revolving credit line that is based on the amount of equity within the home. Home equity lines of credit are often best for those who seek more flexibility as far as accessing the funds.

Home equity loans are a good idea if you know the exact amount of money you need and have no further need after the loan is paid off. Home equity lines of credit are good for people who either want to have the money available, or who would like the flexibility of managing the disbursement of the funds (such as with multiple contractors on a home improvement project).

Also, those who prefer a stable repayment plan may opt for a home equity loan, as those types of loans often come with fixed interest rates. Home equity lines of credit, on the other hand, often come with variable interest rates, so repayment may not be as stable or predictable.

Interest-only mortgage loans explained

Interest-only mortgage loans result in a lower monthly payment because borrowers are only required to pay an interest payment each month, instead of paying on both interest and the principal balance. But although the monthly payment may be lower, potential problems can arise when borrowers don’t make an effort to pay above and beyond the required payment.

Interest-only mortgages can be ideal for people who need the lowest monthly payment possible for one reason or another. People who are self-employed or who work on a commission basis sometimes choose interest only mortgages because this type of loan allows them to make large principal payments during months when their income is substantial, and then lower monthly payments during slimmer months.

If you are interested in this type of loan, it’s a good idea to make additional principal payments beyond the minimum requirement as often as possible. If additional principal payments are made, the original balance of the loan will be slowly decreased over time.

Paying down the principal balance can be beneficial for many reasons, including the fact that it will decrease the amount of interest the borrow will pay in the future.

Common mortgage terms

Every industry makes use of certain terminology and the mortgage industry is no exception. Here is a run down of some regular loan terminology.

Some of the more common terms include PITI, PMI, and title. If you enter the loan process already familiar with these terms, it will help you down the road when other jargon is thrown your way.

PITI is an acronym for the way your mortgage payment will be divided up: Principal balance, Interest, Taxes, and Insurance. You monthly mortgage payments are divided up into these four categories unless you pay your own property taxes or insurance.

PMI is an acronym for Private Mortgage Insurance, which is also sometimes referred to as foreclosure insurance. This insurance is paid by the borrower and is required by most lenders when a substantial down payment (around 20 percent) isn’t made. PMI is not required on all mortgage loans, such as VA guaranteed loans.

The title of a house refers to the legal ownership of the home. A title search will be done to make sure no one else has legal ownership of the home. For example, a divorced couple may not have removed both names from the title, but a refinance could not be done until one of the names was removed. Having a thorough title search protects everyone involved: the buyer, the lender, and the seller

Being familiar with these terms and other basic mortgage terms can help to protect you from jumping into something you don’t fully understand.

More common terms explained

When the time comes to choose your loan terms and sign the papers for your new mortgage , there is plenty of mortgage terminology that will be presented to you.

During the loan process, you will typically be asked to choose between an ARM and a fixed rate. ARM refers to adjustable rate mortgages and fixed rate refers to mortgages with more constant interest rates.

An ARM loan has an interest rate that adjusts according to the predetermined loan terms, so even though you may start out with a low interest rate, it can increase over the life of the loan. A fixed rate mortgage does not feature interest rate adjustments, but the initial interest rate is usually higher than the initial rate of an ARM.

You may also be asked about the length of amortization. This is just another way to ask how many years you want to pay on the loan. Common amortizations include 30, 20 and 15 years for first mortgages.

Another option you might be given is whether you want to pay points on your mortgage. Points refer to a method by which you pay a certain amount of money in order to buy down your interest rate. Some lenders allow you to roll the cost of the points into your loan.

If “balloon payment” enters the discussion, be aware of what this means. A balloon payment is a loan which is payable over a certain amortization (for example, 30 years) but comes due sooner (for example, 10 years). Balloon payments are relatively common for investment properties and interest-only mortgages, but it may be best to avoid this type of loan for your primary residence.

About refinance mortgage loans

Refinancing a home loan involves paying off the current mortgage loan with a new mortgage loan that usually has a lower interest rate and/or a substantially different repayment plan. Lenders offer a wide variety of refinance options for homeowners.

Equity is the amount of money a home is worth minus the amount of money the borrower owes on any outstanding loans attached to the house. Homeowners can turn to the equity in their homes when they have a large expense or require funds to pay for a home improvement project.

A refinance that results in money being distributed to the homeowners is called a cash-out refinance. Borrowers can often get the best cash-out refinance interest loan rates if ther have an abundance of equity in their home, have excellent credit, and choose the shortest amortization available (for example, a term of 15 years instead of 30 years).

When to refinance your mortgage

Mortgage loan refinancing can be a good idea in a variety of instances. One of the most common reasons for refinancing a mortgage loan is to lower the interest rate, and this can certainly be a great reason to refinance your mortgage loan. But how do you know when it’s worth it to take the time to go through a mortgage refinance?

The general rule of thumb regarding mortgage refinancing is that you should lower your loan interest rate by at least one percentage point. In other words, if you currently have an interest rate of 7% and you can refinance into a mortgage loan of 6% or lower, it may very well be worth your effort.

Remember, though, that you will probably need to pay closing costs with your refinance, so you want to make sure that you only refinance when it is truly financially beneficial.

A small drop in interest rates does not merit a rush to refinance your mortgage loan, especially if you have recently refinanced. If you fall into a pattern of refinancing every single time mortgage rates drop you will wind up paying so much in various fees and closing costs that it will take years before the lower interest rate ever saves you some money.

See our refinance interest savings calculator to determine how much refinancing might save you overall and whether or not it is right for you.