Mortgage rates and market dynamics

Mortgage Types

Many types of mortgages exist for the prospective home buyer. The choice of a loan is not an easy one and depends on many factors including current interest rates, estimated time to stay in the house, and current financial status. The purpose of this report was to describe and compare several mortgage types and detail certain situations where one type may provide financial gain over others. Several types of loans that may be obtained are described below:

FHA Loans

The Federal Housing Administration (FHA) is part of the United States Department of Housing and Urban Development and administers various mortgage loan programs. These loans have lower down payment requirements and are easier to qualify for than conventional loans.

VA loans

VA loans are guaranteed by the United States Department of Veterans Affairs. The guaranty allows veterans and service persons to obtain home loans with favorable loan terms, usually without a down payment. Lenders generally limit the maximum VA loan to $203,000.

RHS Loan Programs

The Rural Housing Service (RHS) of the United States Department of Agriculture guarantees loans for rural residents with minimal closing costs and no down payment. Ginnie Mae guarantees securities backed by pools of mortgage loans insured by these three federal agencies; FHA, VA, or RHS. Securities are sold through financial institutions that trade government securities.

State and Local Housing Programs

Many states, counties and cities provide low to moderate housing finance programs, down payment assistance programs, or programs tailored for first time home buyers. These programs are typically more lenient on the qualification guidelines and often designed with lower upfront fees. Most of these programs are fixed rate mortgages and have interest rates lower than the current market.

Conforming Loans

Conventional loans may be conforming and non-conforming. Conforming loans have terms and conditions that follow the guidelines set forth by Fannie Mae and Freddie Mac. These two corporations purchase mortgage loans complying with the guidelines from mortgage lending institutions, packages the mortgages into securities and sell the securities to investors. By doing so, Fannie Mae and Freddie Mac, like Ginnie Mae, provide a continuous flow of affordable funds for home financing that results in the availability of mortgage credit for Americans.

Jumbo Loans

Loans above the maximum loan amount established by Fannie Mae and Freddie Mac are known as 'jumbo' loans. Because jumbo loans are bought and sold on a much smaller scale, they often have a little higher interest rate than conforming loans, but the spread between the two varies with the economy.

B/C/D Loans

Loans that do not meet the borrower credit requirements of Fannie Mae and Freddie Mac are called 'B', 'C' and 'D' paper loans vs. 'A' paper conforming loans. B/C loans are offered to borrowers that may have recently filed for bankruptcy, foreclosure, or have had late payments on their credit reports. The purpose of these loans is to offer temporary financing to these applicants until they can qualify for conforming "A" financing.

Fixed Rate Mortgages fixed-rate loan mortgage keeps the same interest over the course of the loan, regardless of interest fluctuations. With a fixed rate mortgage, the interest rate and your mortgage monthly payments remain fixed for the period of the loan. Generally, the shorter the term of a loan, the lower the interest rate you could get.

The most popular mortgage terms are 30 and 15 years. With the traditional 30-year fixed rate mortgage, monthly payments are lower than they would be on a shorter term loan. But if one can afford higher monthly payments, a 15-year fixed-rate mortgage allows one to repay the loan twice as fast and save more than half the total interest costs of a 30-year loan (Goff and Cox).

The payments on fixed rate fully amortizing loans are calculated so that at the end of the term the mortgage loan is paid in full. During the early amortization period, a large percentage of the monthly payment is used for paying the interest. As the loan is paid down, more of the monthly payment is applied to principal. With bi-weekly mortgage plan, one may pay half of the monthly mortgage payment every 2 weeks. This payment method allows one to repay a loan much faster (typically 18-19 years) compared to a 30-year fixed loan (Dudney, Peterson and Zorn).

Balloon loans

Balloon loans are short-term fixed rate loans that have fixed monthly payments usually based upon a 30-year fully amortizing schedule and a lump sum payment at the end of its term. Balloon loans usually have terms of 3, 5, and 7 years.

The advantage of this type of loan is that the interest rate on balloon loans is generally lower than 30- and 15-year mortgages resulting in lower monthly payments. The disadvantage is that at the end of the term one will have to come up with a lump sum to pay off the lender, either through a refinance or from one's own savings.

Balloon loans with refinancing option allow borrowers to convert the mortgage at the end of the balloon period to a fixed rate loan, based upon the outstanding principal balance, if certain conditions are met. The interest rate on the new loan is a current rate at the time of conversion. The most popular terms are 5/25 Balloon, and 7/23 Balloon.

Adjustable Rate Mortgages

An adjustable rate mortgage (ARM) is one in which the interest rate may fluctuate depending on interest rates. Mortgage payments are typically lower than a fixed rate mortgage for the first 3-5 years. However, interest rates may rise at much as 2% per year and up to 6% over the entire loan period (Lindsay). For example, an ARM that starts at 6% may increase to 8% in the second year, to 10% in the third year, and to 12% in the fourth year. Over this period, the monthly payment may nearly double. On the other hand, when interest rates are in a decline, such as during a recession, ARM rates tend to remain low.

All adjustable rate mortgages have a lifetime rate cap (ceiling), which limits the amount the interest rate of the loan can increase over the life of your loan. Most adjustable rate mortgages also have a periodic rate cap, which limits the amount of rate increase for each adjustment. Many different types of ARMs exist. Several of these are described in detail below:

1-Year Adjustable Rate Mortgage

1-year adjustable rate mortgage is a 30-year loan in which the rate changes every year on the anniversary of the loan initiation. This type of loan is considered very risky because the payment may change significantly from year to year.

3-Year Adjustable Rate Mortgage

3-year adjustable rate mortgage is a 30-year loan in which the rate changes every 3 years. This loan is risky, although it is safer than the 1-year adjustable rate mortgage because the interest rate does not adjust as frequently.

5-Year Adjustable Rate Mortgage

5-year adjustable rate mortgage is a 30-year loan in which the rate changes every 5 years. This loan is generally considered a compromise between shorter-term adjustable rate mortgages and fixed rate programs due to the infrequent interest rate adjustments.

3/1 Adjustable Rate Mortgage

3/1 adjustable rate mortgage is a 30-year loan that offers a fixed interest rate for the first 3 years and then turns into a 1 year adjustable rate mortgage for the remaining 27 years of the loan.

5/1 Adjustable Rate Mortgage

5/1 adjustable rate mortgage is a 30-year loan that offers a fixed interest rate for the first 5 years and then turns into a 1 year adjustable rate mortgage for the remaining 25 years of the loan.

7/1 Adjustable Rate Mortgage

7/1 adjustable rate mortgage is a 30-year loan that offers a fixed interest rate for the first 7 years and then turns into a 1 year adjustable rate mortgage for the remaining 23 years of the loan.

10/1 Adjustable Rate Mortgage

10/1 adjustable rate mortgage is a 30-year loan that offers a fixed interest rate for the first 10 years and then turns into a 1 year adjustable rate mortgage for the remaining 20 years of the loan.

The margin is fixed percentage points added to the index to compute the interest rate. The result will then be rounded to the nearest one-eighth of a percent. The margins remain fixed for the term of the loan and are not impacted by the financial markets and movement of interest rates. Lenders use a variety of margins depending upon the loan program and adjustment periods.

Most ARMs have an interest rate caps to protect you from enormous increases in monthly payments. A lifetime cap limits the interest rate increase over the life of the loan. A periodic or adjustment cap limits how much your interest rate can rise at one time.

Negatively amortizing loans

Some types of ARMs offer payment caps rather than interest rate caps, which limit the amount the monthly payment can increase. If a loan has a payment cap, but has no periodic interest rate cap, then the loan may become negatively amortized. That is, if the interest rates rise to the point that the monthly mortgage payment does not cover the interest due, any unpaid interest will be added to the loan balance, so the loan balance increases. However, one also has the option to pay the minimum monthly payment, or the fully amortized amount due.

The advantage of negatively amortizing loans is that one can control cash flow with a relatively stable payment, take advantage of low interest rates relative to the market at any given time, and pay back the money borrowed today at a depreciated value years from now because of natural inflation.

With most ARMs, the interest rate can adjust every 6 months, once a year, every 3 years, or every 5 years. The interest rate on negatively amortized loans can adjust monthly. A loan with an adjustment period of 6 months is called a 6-month ARM, with an adjustment period of 1 year is called a 1-year ARM, and so on. Most ARMs offer an initial lower interest rate than the fully indexed rate (index plus margin) during the initial period of the loan, which could range from 1 month or a year or more.

Fixed-period ARMs

With fixed-period ARMs typically result in 3-10 years of fixed payments before the initial interest rate change. At the end of the fixed period, the interest rate will adjust annually. Several types of fixed-period ARMs exist, including 30/3/1, 30/5/1, 30/7/1 and 30/10/1. These loans are typically linked to the 1-year Treasury securities index. Adjustable rate mortgages with an initial fixed period usually have a first adjustment cap. This cap limits the interest rate one pays the first time the rate is adjusted. However, first adjustment caps vary with type of loan program.

The advantage of these loans is that the interest rate is lower than for a 30-year fixed because the lender is not locked in for as long so their risk is lower and they can charge less. However, one still gets the advantage of a fixed rate for a period of time.

Two-Step Mortgage

Two-step mortgages have a fixed rate for a certain time, most often 5 or 7 years, and then interest rate changes to a current market rate. After that adjustment the mortgage maintains new fixed rate for the remaining 23 or 25 years.

Convertible ARMs

Some ARMs come with option to convert them to a fixed-rate mortgage at designated times, usually during the first 5 years on the adjustment date. The new rate is established at the current market rate for fixed-rate mortgages. The conversion is typically performed for a nominal fee and requires virtually no paperwork. The disadvantage is that the conversion interest rate is typically a little higher than the market rate at that time.

The other kind of convertible mortgage is a fixed rate loan with rate reduction option. If rates have dropped since the time of closing, it allows one under some prescribed conditions for a small conversion fee to adjust the mortgage to the current market rate. Generally, the interest rate or discount points may be a slightly higher for a convertible loan.