What About Short-Term Fixed, Amortized over 30 Years?

What About Short-Term Fixed, Amortized over 30 Years?

The whole point behind an ARM, from a lender’s perspective, is to give a loan that can respond to interest rate fluctuations. Another way of accomplishing this is to give a shorter-term fixed-rate mortgage.

Currently lenders are offering short-term fixed-rate mortgages in the following time lengths, all amortized over 30 years, 15 years, 10 years, 7 years, 5 years, or 3 years. The shorter the term, the better the interest rate is. What this means is that after the initial period, you have a “balloon,” a single large payment where the remaining balance is due.

For example, you can get an interest rate reduction if you agree to get a loan with a balloon in 15 years (see the following). You might get an even bigger reduction if you agree to a balloon in 10 years instead of 15. If you agree to a balloon in 3, you might get the interest rate reduced the most. (Note: The monthly payments can still be spread out—amortized—on the basis of 30 years. It’s just that you have a shorter due date, or balloon payment at the end.)

TRAP—BEWARE OF THE BIG BALLOON PAYMENT AT THE END

On short-term fixed-rate mortgages, if it turns out that you can’t sell or refinance as you planned at the end of the term, you could lose the property to foreclosure! You’re gambling a lower interest rate on future market and personal financial conditions. Therefore, make sure a shorter-term mortgage includes an automatic refinancing option at the end. Usually this is an ugly adjustable, but at least if worse comes to worst, you won’t be without a loan.

Hybrid mortgages are available from banks, savings institutions, and mortgage brokers—anywhere that you’d get any other type of mortgage. However, your best sources are the mortgage brokers, who deal with many lenders, and thus have a better sense of what’s out there.

Balloon or Amortize (Spread Out) Payments?

You should get a balloon mortgage:

■ If you plan on reselling or refinancing soon

■ If you need a lower interest rate

■ If you can lock in a “roll-over” loan to cover the balloon when it comes due

You should get a fully amortized (paid off) mortgage:

■ If you want equal payments to fully pay off the loan

■ If you plan on keeping the property a long time

■ If the risk of a big balloon payment (or having to take out a high-interest roll-over loan) bothers you

What About a Fully Amortized 15-Year Mortgage?

Some people simply want a shorter mortgage. As opposed to the hybrids just discussed, in a fully amortized shorter-term mortgage, the payments are higher so it can be fully paid off at the end of, say 15 years. (With a hybrid, you have lower payments, but a balloon at the end—here the mortgage is paid completely.)

The advantage here is much less interest over time. With a 30-year amortized mortgage the total interest is more than twice as much at the same interest rate than with a 15-year fully amortized mortgage! Of course, you may be saying to yourself that this is all well and good—yes, you save more than half the interest. But you probably more than double your payments.

Comparing Adjustable-Rate with Fixed-Rate Mortgages

 

Now we’re at the stage of comparing apples with oranges. However, in truth, a direct one-to-one comparison isn’t usually very helpful. Rather, what’s more important to most borrowers is comparing the usefulness of each type. It’s sort of like saying, “Do I want to eat an orange now, or will an apple taste better?” Here are some guidelines that may prove helpful.

When interest rates are low, get a fixed-rate mortgage to lock in the low rate. When interest rates are high, consider an adjustable-rate mortgage with payments that will fall as interest rates come down.

If you desperately want to buy a home but can’t qualify for a fixed-rate mortgage, try an adjustable. The lower teaser rate should make qualifying a bit easier. (Currently lenders qualify not just on the basis of the teaser, but on an average between the market rate and the teaser, which is still probably lower than for a comparable fixed-rate mortgage.)

If you can’t afford to have fluctuations in your monthly payment, get a fixed-rate mortgage. You’ll at least know what your payments will be every month.

If you plan to sell soon, get an ARM and take advantage of the low teaser rate. But beware, your plans could change unexpectedly!

Sometimes ARMs have lower initial loan costs. If cash is a big consideration for you, look into them. Remember that with an ARM, if interest rates go up, so do your payments. (This may occur even after rates have peaked and started to come down. Because of your adjustment period, you may play “catch-up” for months after the downturn.) You can’t call your lender later and say, “I can’t handle a $200 increase in my monthly payment!” Your lender isn’t going to be sympathetic and will threaten you with foreclosure if you don’t pay. The time to consider a big monthly increase is before you get that adjustable-rate mortgage, not afterward.

Fixed- or Variable-Rate Mortgage?

You should get a fixed-rate mortgage:

■ If you can lock in a low-interest rate

■ If you plan on keeping the property a long time

■ If you want a fixed mortgage payment (does not go up or down)

You should get a variable rate mortgage:

■ If interest rates are high and you can get a long-term, low initial (teaser) rate

■ If you plan on selling or refinancing soon

■ If you can handle flexible mortgage payments (that can rise during the life of the loan)

Hybrids: What About a Combination Fixed and Adjustable?

There are a whole bunch of hybrids out there, any one of which may be better for your situation than a straight fixed or ARM mortgage.

What Is a Convertible Mortgage?

Some ARMs may be “convertible” to a fixed rate, or vice versa. Many allow a conversion at a set date—three or seven years, for example— in the future. Just be sure the conversion is guaranteed at the lowest interest rate at the time of conversion.

There are literally hundreds of types of convertible mortgages available. Some lenders will even create one just to suit your financial situation. Be sure to ask.

What About Short-Term Fixed, Amortized over 30 Years?

The whole point behind an ARM, from a lender’s perspective, is to give a loan that can respond to interest rate fluctuations. Another way of accomplishing this is to give a shorter-term fixed-rate mortgage.

Currently lenders are offering short-term fixed-rate mortgages in the following time lengths, all amortized over 30 years, 15 years, 10 years, 7 years, 5 years, or 3 years. The shorter the term, the better the interest rate is. What this means is that after the initial period, you have a “balloon,” a single large payment where the remaining balance is due.

For example, you can get an interest rate reduction if you agree to get a loan with a balloon in 15 years (see the following). You might get an even bigger reduction if you agree to a balloon in 10 years instead of 15. If you agree to a balloon in 3, you might get the interest rate reduced the most. (Note: The monthly payments can still be spread out—amortized—on the basis of 30 years. It’s just that you have a shorter due date, or balloon payment at the end.)

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How to Compare Variable-Rate Mortgages?

Variable-rate, also called adjustable-rate, mortgages (ARMs) can also be compared, except that many more factors are involved. The first thing you’ll notice is that the interest rates usually will seem much lower for ARMs than for fixed-rate loans. Once again, don’t be fooled. Remember, compare apples with apples, not with oranges.

The low initial interest rate (often called the teaser) is the traditional appeal of ARMs. As such, they appear to be giving you a better deal. But it isn’t necessarily so.

There are a number of different factors to take into account when comparing variable/adjustable-rate mortgages. We’ll cover six of the most important:

■ Teaser rate

■ Caps

■ Indices

■ Margin

■ Adjustment period

■ Steps

What Is a Teaser Rate?

Most ARMs have a low beginning interest rate. This is usually only a teaser, a come-on to get you to sign up for the ARM. Often the teaser is several percentage points below the true rate. What this means is that in the first few adjustment periods, your effective interest rate will rise even if interest rates in general do not!

As an example, the discounted teaser rate may be 4 percent and the true market rate may be 7. You get the ARM at 4 percent. However, if it has 3-month adjustment periods with a maximum adjustment of 1 percent in interest each period, within 9 months it will be up to 7 percent. Your interest rate will go up 1 percent the first 3-month period, 1 percent the second 3-month period, and 1 percent the third 3-month period, so that 9 months after you get the loan you are paying 7 percent instead of 4.

Additionally, some of these loans are written in such a way that the interest rate will continue on up to make up for the below-market interest rate you received as part of the teaser. So your interest rate could continue on up beyond 7 percent for a time!

Remember, the teaser rate is only temporary. Don’t be fooled into thinking that it is the true rate of your mortgage. Ask the lender what the true rate is. You’ll be shown the APR (annual percentage rate), which will be higher than the teaser but probably still not as high as the current market rate of the mortgage (because the APR is a blending of the teaser and the current mortgage rate).

When comparing ARMs, it’s usually to your advantage to go for the one where the teaser lasts the longest, thus maximizing your period of low interest rates.

What Are Caps?

Adjustable rates often have caps limiting the maximum amount that the interest rate can rise over the term of the loan and the adjustment period. Rate caps prevent the interest rate on a variable rate mortgage from rising indefinitely.

Some loans offer payment caps, where the amount the monthly payment can rise (to compensate for a rising interest rate) is also capped. It sounds like a good idea, but in reality it can be a trap. Monthly payment caps often lead to negative amortization, which, simply put, means that you end up owing more than you originally borrowed!

Negative amortization happens when the interest rate goes up and your monthly payment does not. In this case, each month you may not be paying enough to meet just the interest on the mortgage, let alone repaying the principal.