There are two basic types of mortgages, Fixed and Adjustable. The following is a brief explanation.
FIXED RATE MORTGAGE
A fixed rate mortgage means the principal and interest rate (PI) portion of your mortgage payments will remain the same for the duration of the loan. Typical periods for Fixed Rate Mortgages are 15, 20, 25, 30 and even 40 years.
An adjustable rate mortgage means that the mortgage payments will change during the duration of the loan. These mortgages normally start with an initial Fixed Interest Rate (typically with a 1, 3, 5, 7, or 10 year period) before they start to adjust.
To understand fully how and when your payments will adjust, there are two factors involved: Index and Margin. The Index is the interest rate the Lender is being charged to borrow the money for your mortgage. Because this money is borrowed on a short term basis, this interest rate “floats” with what ever the market dictates. The Margin is a fixed number of percentage points that the lender adds to the index rate for their profit. To calculate the actual ARM interest rate, the Index and Margin are added together at each adjustment period.
The most popular Indexes the Lenders utilize are LIBOR and Treasury Notes. Each index is sold in specific periods of time for the bank to borrow the money. This assures the bank is borrowing money at a fixed cost to them – for that period of time. If the loan surpasses that initial period of time, the bank must re-borrow that money to keep the loan for the homebuyer. When the rate they are charged changes, so does yours.
For example:
Initial Index 2.53 - Bank Margin 2.50 - Your initial Interest rate is 5.03
Index 3 years from Today 3.95 - Bank Margin 2.50 - Your new Interest rate is 6.45
There are numerous Caps that also are of great interest to anyone who secures an Adjustable Rate mortgage. Some Caps of interest are the maximum interest rate it can move in a period, the maximum interest rate for the life of the loan and how often the interest rate can be adjusted. We do not want to make you financial wizards here, so please ask your Mortgage professional for greater details.
Read this as many times as you need to in order to understand it and ask questions until you fully understand how an Adjustable Rate works. They can be great loans for homebuyers who understand them and earn enough income to sustain fluctuations in their mortgage payments during the term of the loan.