Home Buying Series Part II: An Introduction to Mortgages

Now that you used Zillow to help you find a good home at a good price it's time to think about how you will finance that home. That's where a mortgage comes in. At its most basic level, a mortgage is a loan from a financial instituion to you which has your house as collateral. In laymen's terms, the bank has a claim on your house and if you don't pay them their interest, they'll take the house as payment instead (i.e. foreclose).

Fixed Mortgages

Fixed mortgages are mortgages that are at a fixed rate interest rate over the life of the loan. For a 30-year fixed mortgage both interest and principal will be amortized (i.e. spread out) over 30 years so at the end of year 30 you will owe $0 to the bank and own your home outright. A 15-year fixed mortgage will result in a zero balance at the end of year 15. Typically the shorter the duration of the mortgage the lower the interest rate you'll have to pay, but the higher your monthly payment will be (because your principal is amortized over a shorter period of time). Fixed mortgages give you the security of stable payments over the life of your loan, but usually carry slightly higher rates to begin with than ARMs. If you plan on staying in your house for over 7 years, I'd advise sticking with a fixed rate mortgage.

Adjustable Rate Mortgages (ARMs)

ARMs are loans that start out at a fixed rate for a certain period of time and then begin to adjust every so often (usually once per year). Usually there is a particular interest rate to which the ARM is tied which in ARM lingo is called an index. As the index goes up, so the rate on your ARM goes up. Common ARM indexes include: COFI, MTA, CODI, Prime Rate, and LIBOR.

Most ARMs come with a period cap and a lifetime cap. The period cap is the maximum amount your rate can adjust up in any given period. For many annually adjusting ARMs this is around 2%. This means if you start out paying 5% then the most your ARM can adjust to is 7% after its first adjustment period and 9% after the second, etc. A lifetime cap represents the maximum amount your interest rate can go up over the course of the loan. For many ARMs this is 6%. So if you start out at 5% with a 6% lifetime cap, the most you can ever pay is 11% (which is a lot especially compared to the 5% teaser rate).

You may have seen 3/1 ARMs and 5/1 ARMs. These are loans that start out fixed at the low teaser rate for the same number of years as the first digit (i.e. 3 years or 5 years). The second digit represents how often the ARM adjusts after the fixed period, these loans adjust once per year as is typical.

So by now you have probably figured out that ARMs can be pretty complicated. If you plan on living in a house for only 5 years, then a 5/1 ARM can probably save you money because you will pay a low rate for the first 5 years and then sell the house (and pay off your loan in full) so you won't be paying when the chance for higher rates hits. Other than that, taking out an ARM is a gamble on interest rates which very few people can predict accurately. Generally, I would advise against ARMs unless you plan on paying off your loan in full before the ARM adjusts.

As a side note, if you need to use an ARM to afford a house, you are buying a house that is beyond your means! Do NOT do it as you are likely to end up in financial trouble by the time your ARM floats. You can always move to a bigger house later, but recovering from bankruptcy is much harder to do (i.e. takes 7 years at least). If you need an ARM to afford your house, do the right thing and find a smaller house that you can afford with a fixed rate mortgage. My next post will walk you through how much house you can afford.

Loans to Avoid: IO and Neg Am

There are also a couple of loans worth outright avoiding for the average individual. These include IO (Interest Only) loans and Neg Am (Negative Amortization) loans. These are loans that are for the most part designed to get people who can't afford a certain house into that house. They are very risky and will usually end in financial ruin for the homeowner. Indeed many financial instutions that were pushing these types of loans recently went bust when the homeowners who had these loans defaulted on them. Unless you REALLY know what you are doing these types of loans are to be avoided at all costs.