How mortgages work
By Bankrate

There are as many types of mortgages to choose from as there are types of houses to buy. Here you'll learn how to choose the mortgage that is right for you -- and what kind of lender to get it from.
There's a lot to learn in this chapter, since there are all kinds of ways to finance your home. We'll tell you about fixed-rate and adjustable-rate mortgages, as well as subprime mortgages for those who have credit problems. We also explain the less-well-known kinds -- jumbo, balloon and others. Finally, we discuss the different types of lends and tell you which ones are the best choices in different financial situations.

Fixed-Rate mortgages

Lenders offer several types of mortgages, but the most common are fixed-rate mortgages. These loans feature fixed rates and monthly payments, generally for 15-year and 30-year periods.
They're popular because:

• Consumers balk at the thought of their house payment rising and falling with interest rates.
• Whenever rates are low, fixed-rate mortgages are very affordable.

Fixed-rate loan borrowers face one major choice: 15 year or 30? For some, a 30-year loan makes more sense. For others, a 15-year one does. Here are some pros and cons of each.

30-year Fixed Rate

Advantages
• Offers the chance to borrow money on a long-term basis without having to worry about the interest rates or payments changing.
• Monthly payments are lower than those on 15-year loans because the interest is amortized over a longer period.
• Lower monthly payments free up money that borrowers can pour into investments that yield more than their homes.
• Higher interest bill increases the amount consumers can deduct at tax time, potentially reducing or eliminating their federal income tax liabilities.

Disadvantages
• Borrowers build equity at a very slow pace because payments during the first several years go largely toward interest rather than principal.
• The overall interest bill is much higher because of the long amortization term.
• The interest rates are higher than on 15-year loans.

15-year Fixed Rate

Advantages
• Borrowers build equity much more quickly due to shorter amortization schedules.
• Overall interest bills are dramatically lower than those on longer-term loans.
• The interest rates are lower than 30-year loans.

Disadvantages
• Monthly payments can be significantly higher than those on 30-year loans.
• Restricts home buyers to smaller house than they might be able to afford with longer-term loans.

Example
Say you have a $150,000 mortgage. Let's compare how much money you would pay out in interest over 30 years vs. 15 years. The following chart shows the numbers. The monthly loan payments are principal and interest only. As you can see, with a 15-year loan, you would save $117,001 in interest.

Interest cost: 30-year vs. 15 year mortgages

Other factors to consider
Take the example above: With the 15-year loan, the monthly mortgage payment is $313 more than the 30-year mortgage. You may want to put that money toward another investment. For instance, in a bull-market economy, you can make more money investing that $313 monthly in mutual funds or other investment securities.

Keep in mind that there are ways to prepay your mortgage and whittle away at the principal each month, so that the loan is paid off sooner than 30 years.

Also, it depends on how long you plan to own the home you are purchasing. If it's less than five years, you may be better off with an adjustable-rate mortgage, or ARM.

Adjustable-Rate mortgages

Adjustable-rate mortgages, or ARMs, differ from fixed-rate mortgages in that the interest rate and monthly payment move up and down as market interest rates fluctuate.

Most have an initial fixed-rate period during which the borrower's rate doesn't change, followed by a much longer period during which the rate changes at preset intervals.

Adjustable rates start low
Rates charged during the initial periods are generally lower than those on comparable fixed-rate mortgages. After all, lenders have to offer something to make it worth their while to assume the risk of higher rates in the future.

The initial fixed-rate period can be as short as a month or as long as 10 years. One-year ARMs, which have their first adjustment after one year, used to be the most popular adjustable, and were the benchmark. Recently the standard has become the 5/1 ARM, which has an initial fixed-rate period that lasts five years; the rate is adjusted annually thereafter. That type of mortgage, which mixes a lengthy fixed period with an even lengthier adjustable period, is known as a hybrid. Other popular hybrid ARMs are the 3/1, the 7/1 and the 10/1.

These hybrid ARMs -- sometimes referred to as 3/1, 5/1, 7/1 or 10/1 loans -- have fixed rates for the first three, five, seven or 10 years, followed by rates that adjust annually thereafter.

After the fixed-rate honeymoon, an ARM's rate fluctuates at the same rate as an index spelled out in closing documents. The lender finds out what the index value is, adds a margin to that figure and recalculates the borrower's new rate and payment. The process repeats each time an adjustment date rolls around.

Major Indexes

Most ARM rates are tied to the performance of one of three major indexes:

• Weekly constant maturity yield on the one-year Treasury Bill
The yield debt securities issued by the U.S. Treasury are paying, as tracked by the Federal Reserve Board.
• 11th District Cost of Funds Index (COFI)
The interest financial institutions in the western U.S. are paying on deposits they hold.
• London Interbank Offered Rate (LIBOR)
The rate most international banks are charging each other on large loans.

Sky's not the limit
Borrowers have some protection from extreme changes because ARMs come with caps. These caps limit the amount by which ARM rates and payments can adjust.

Caps come in a couple of different forms. The most common are:

• Periodic rate cap: Limits how much the rate can change at any one time. These are usually annual caps, or caps that prevent the rate from rising more than a certain number of percentage points in any given year.
• Lifetime cap: Limits how much the interest rate can rise over the life of the loan.
• Payment cap: Offered on some ARMs. It limits the amount the monthly payment can rise over the life of the loan in dollars, rather than how much the rate can change in percentage points.

Interest-only ARMs

Around the turn of the 21st century, lenders began to market interest-only mortgages to middle-class borrowers. Formerly the preserve of what lenders called "affluent clients," interest-only mortgages are usually adjustables. The borrower is required to pay only the interest for a specified period, often 10 years. After that, it adjusts to the going interest rate, as tracked by a specified index. After that, the loan amortizes at an accelerated rate. During the interest-only period, the borrower can choose to pay some principal, too. By providing flexibility in the size of monthly payments, interest-only mortgages often are a good match for people with fluctuating monthly incomes: salespeople who are paid by commission, for example.

Variety of flavors

Some ARMs come with a conversion feature that allows borrowers to convert their loans to fixed-rate mortgages for a fee. Others allow borrowers to make interest-only payments for a portion of their loan terms to keep their payments low. But no matter the exact terms, most ARMs are more difficult to understand than fixed-rate loans.

To keep your financial options open, make sure to ask the mortgage lender if the ARM is convertible to a fixed-rate mortgage. Also, ask if the ARM is assumable, which means when you sell your home the buyer may qualify to assume your existing mortgage. That could be desirable if mortgage interest rates are high.

ARM vs. Fixed-Rate mortgage

Which is the better mortgage option for you: fixed or adjustable?

The low initial cost of adjustable-rate mortgages, or ARMs, can be very tempting to home buyers, yet they carry a degree of uncertainty. Fixed-rate mortgages offer rate and payment security, but they can be more expensive.

Here are some pros and cons of ARMs and their fixed-rate brethren.

Adjustable-Rate mortgages

Advantages
• Feature lower rates and payments early on in the loan term. Because lenders can use the lower payment when qualifying borrowers, people can buy larger homes than they otherwise could buy.
• Allow borrowers to take advantage of falling rates without refinancing. Instead of having to pay a whole new set of closing costs and fees, ARM borrowers just sit back and watch the rates -- and their monthly payments -- fall.
• Help borrowers save and invest more money. Someone who has a payment that's $100 less with an ARM can save that money and earn more off it in a higher-yielding investment.
• Offer a cheap way for borrowers who don't plan on living in one place for very long to buy a house.

Disadvantages
• Rates and payments can rise significantly over the life of the loan. A 6 percent ARM can end up at 11 percent in just three years if rates rise sharply.
• The first adjustment can be a doozy because some annual caps don't apply to the initial change. Someone with an annual cap of 2 percent and a lifetime cap of 6 percent could theoretically see the rate shoot from 6 percent to 12 percent 12 months after closing if rates in the overall economy skyrocket.
• ARMs are difficult to understand. Lenders have much more flexibility when determining margins, caps, adjustment indexes and other things, so unsophisticated borrowers can easily get confused or trapped by shady mortgage companies.
• On certain ARMs, called negative amortization loans, borrowers can end up owing more money than they did at closing. That's because the payments on these loans are set so low (to make the loans even more affordable) they only cover part of the interest due. Any additional amount due gets rolled into the principal balance.

Fixed Rate Mortgages

Advantages
• Rates and payments remain constant. There won't be any surprises even if inflation surges out of control and mortgage rates head to 20 percent.
• Stability makes budgeting easier. People can manage their money with more certainty because their housing outlays don't change.
• Simple to understand, so they're good for first-time buyers who wouldn't know a 7/1 ARM with 2/6 caps if it hit them over the head.

Disadvantages
• To take advantage of falling rates, fixed-rate mortgage holders have to refinance. That means a few thousand dollars in closing costs, another trip to the title company's office and several hours spent digging up tax forms, bank statements, etc.
• Can be too expensive for some borrowers, especially in high-rate environments, because there is no early-on payment and rate break.
• Are virtually identical from lender to lender. While lenders keep many ARMs on their books, most financial institutions sell their fixed-rate mortgages into the secondary market. As a result, ARMs can be customized for individual borrowers, while most fixed-rate mortgages can't.

All of these things should factor into your decision between a fixed-rate mortgage and an adjustable. But there are other important questions to answer when deciding which loan is better for you:

1. How long do you plan on staying in the home?
If you're only going to be living in the house a few years, it would make sense to take the lower-rate ARM, especially if you can get a reasonably priced 3/1 or 5/1. Your payment and rate will be low and you can build up more savings for a bigger home down the road. Plus, you'll never be exposed to huge rate adjustments because you'll be moving before the adjustable rate period begins.

2. How frequently does the ARM adjust, and when is the adjustment made?
After the initial fixed period, most ARMs adjust every year on the anniversary of the mortgage. The new rate is actually set about 45 days before the anniversary, based on the specified index. But some adjust as frequently as every month. If that's too much volatility for you, go with a fixed-rate mortgage.

3. What's the interest rate environment like?
When rates are relatively high, ARMs make sense because their lower initial rates allow borrowers to still reap the benefits of homeownership. Rates could fall even further, meaning borrowers will have a decent chance of getting lower payments even if they don't refinance. When rates are relatively low, however, fixed-rate mortgages make more sense. After all, 7 percent is a great rate to borrow money at for 30 years.

4. Could you still afford your monthly payment if interest rates rise significantly?
On a $150,000, one-year adjustable-rate mortgage with 2/6 caps, your 5.75 percent ARM could end up at 11.75 percent, with the monthly payment shooting up as well.

How adjustable rates can rise:

Year of ARM	Rate	Monthly payment
First year	5.75%	$875
Second year	7.75%	$1,075
Third year	9.75%	$1,289
Fourth year (6% lifetime cap)	11.75%	$1,514 ($639 more than first year)

Now, let's compare this worst-case ARM scenario to a fixed-rate mortgage:

Interest rate during 4 years	Total payments during 4 years
ARM: 5.75% to 11.75%	$57,036
Fixed rate: 7.75%	$51,600
Savings with fixed-rate mortgage over 4 years: $5,436.

In the above case, the fixed-rate mortgage costs less than the worst-case ARM scenario. Experts say when fixed mortgage rates are low, they tend to be a better deal than an ARM, even if you only plan to stay in the house for a few years.