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Understanding Mortgage Loans and Interest Rate Types

Twenty years ago, your typical lender offered only two loan products, a fixed rate loan with fixed payments over fifteen or thirty years or a credit that can be changed every year. Today, lenders offer a bewildering array of loan products, making it difficult for consumers to fully understand their loan, interest rates and interest rates. the interest they pay in the future.

The purpose of this wide range of financial products is to meet the needs of the customer, often lowering the monthly payment, increasing the loan (which allows the purchase of a more expensive home) or reducing the payment. -money needed for the traditional twenty percent with little or no down payment.

Traditional loans are based on a fixed interest rate and are called fixed rate loans. These loans have one interest rate for the entire term. In real estate, the typical amortization period is 15 or 30 years. While a 15-year loan results in a higher monthly payment, this loan also reduces the amount owed to the borrower, resulting in a significant reduction in the balance of the 5 years after 5 years (household owners generally stay 5 – 7 years in it. a house). As you can see in Table 1, an additional payment of $1,195.20 per month will save you the following:

.
.                                                                    15 year mortgage                                                      30 year mortgage
Monthly Payment                                              $4,355.54                                                                 $3,160.34
Balance due after five years                            $383,585.40                                                             $468,054.87
Principal Reduction                                            $116,414.60                                                             $31,945.13
Cost Savings:                                                     $12,757.47

Another type of fixed rate mortgage is the seven-year balloon. This loan has a fixed interest rate and 15 or 30 year amortization, but it matures in 7 years which requires the borrower to repay or satisfy the loan at that time. This type of loan is typically priced 12.5 to 25 basis points lower than a regular fixed-rate loan, and is best used by people planning to sell before the mortgage balloon.

Refinance loans come in many different forms and are often the source of consumer confusion. In addition to adjusting the interest rate, borrowers have to worry about indexes, margins, caps, prepayment penalties and bad loan forgiveness, considerations that do not come with loans. regular regular credit.

Each item affects the amount of the payment, the interest paid and the possibility of higher payments in the climate of increasing interest rates (expected to start next year). The index used in the adjustment rate chart defines the baseline against which to measure the increase (or decrease) in the loan’s performance rate. Common indexes are the treasury rate, LIBOR, the prime rate and the COFI rate. These rates tend to follow similar up and down movements but at different speeds and rates so they can be out of sync by as much as 25 basis points (.25%) at any one time.

The most common rate is the treasury index, which is based on one-year US Treasury bills. These are calculated as the average yield on the United States Treasury which is adjusted to constant maturity over one year, and is carried out by the Federal Reserve Board of the United States. The second most common rate is LIBOR, short for the London Inter-Bank Offered Rate. This rate is the rate that some banks in London offer for bank deposits.

The Prime Rate generally refers to the rate at which the bank offers its customers the best loan. The Wall Street Journal publishes a composite rate for a group of financial institutions, and this rate, known as the Wall Street Journal Prime Rate, is often used when discussing mortgages. at a cost. Because the WSJ Prime Rate is much higher than the other three, the rates are not directly comparable.

The most common rate is the COFI, or Cost of Funds Index for the 11th District of the Federal Reserve. This index is based on a weighted average of the cost of loans in the banking institutions of the Federal Home Loan Bank of San Francisco.

Each rate has its advantages and disadvantages related to the speed of rate adjustment and increase. Prime Rates are moving slowly but in big jumps, and the COFI index is trending in the opposite direction (which is better in a rising rate market and worse in a bear market). discount). LIBOR has the most volatility and responds to market forces the fastest. These changes are shown in Table 2.

The next factor to consider in an adjustable rate loan is the margin rate. The margin rate measures the amount added to the index to determine the actual rate paid to the borrower. This number is important, because the larger the margin, the higher the ratio. A traditional 1-year ARM had a 2-digit index, with the 2 digits added to the index rate to calculate the loan-to-value ratio. This margin has been higher with many loans having margins of 3 basis points above the Treasury benchmark or LIBOR.

Knowing the margin of the loan is especially important because most loans start at an artificially low rate known in the business as the “subsidy rate.” The teaser rate only lasts for one to twelve months, and then the rate jumps to a higher index-based rate plus margin, subject to all restrictions. These test rates have led to unqualified buyers entering homes, with monthly payments often doubling after the first year.

The loan cap dictates the limits of interest rate movements on the loan. Two types of caps are used on most mortgages, the modification date cap and the lifetime cap. The change date limit limits the maximum increase in the loan at the time of the interest rate change. Usually limited to 2 digits, this prevents the loan from increasing significantly due to low teaser rates or changes in interest rates. A lifetime cap dictates the maximum interest rate the loan can accrue. This is normally 6 digits, but with a loan with a low teaser rate, the lifetime limit can be 10 or 12 digits.

Adaptable loans come in many flavors. In addition to a one-year ARM, you can get a 3/1, 5/1, 7/1 or 10/1 ARM loan, which fixes the rate from 3 to 10 years, and then becomes one year after which it can be repaired. These loans sometimes have better rates than fixed-rate loans, and when combined with a 2-digit cap, they’re often a better financial deal if the borrower knows they’ll be moving. them before the rates go up. On the other hand is the monthly adjustable loan, which allows a low starting rate but the possibility of a larger increase due to the increase of monthly interest in the economy with the rate the interest.

Many lenders offer ARM loan options that allow for either type of payment. Arrangements varied, but the most common version was called a four-payment ARM that allowed for 4 monthly payments. Borrowers of this program can pay the loan based on 15 years of amortization, 30 years of amortization, interest only, or the lowest payment. Table 3 shows the different payment options for a $500,000.00 loan at a rate of 6.5%.

Payment Option                                            Amount due per month
15 year loan payment                                         $4,355.54
30 year loan payment                                         $3,160.34
Interest Only                                                      $2,708.33
Minimum Payment                                              $2,166.66

Option ARMs have also created many problems today because most people only paid the minimum amount due, increasing their debt at a time when housing prices were falling. This increased the risk of the loan balance exceeding the value, and forced many people into foreclosure.

Due to the wide variety of loan products, prudent borrowers should carefully review the loan they are offered to ensure that the promised product is what the customer expects. Not paying attention can be costly, as a difference of just 25 basis points can cost you $37,500 over the life of a 30-year loan.

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