TRADITIONAL LOAN PROGRAMS

Although you may see many different types advertised, they all belong to two families: mortgages that carry fixed interest rates, and those whose rate changes during the course of the loan, on a periodic schedule mutually agreed upon by you and your lender.

Below we discuss the main features of fixed rate mortgages and adjustable rate mortgages along with the advantages and disadvantages of each. This discussion is applicable to New Jersey mortgage finance, New York mortgage finance and Pennsylvania mortgage finance.

Fixed Rate Mortgages

The interest rate on fixed rate mortgages is fixed over the life of the loan and never changes. fixed rate mortgages are usually "fully amortizing" over the life of the loan. That means that the amount initally borrowed is completely paid back over the life of the loan. The major advantage of fixed rate mortgages is that they provide predictable housing costs. The montly loan payment never changes. Therefore, fixed rate mortgages are especially attractive in a rising interest rate environment.

Your total monthly housing payment may increase even though you have a fixed rate mortgage. Since you pay a portion of the annual property taxes and homeowners insurance every month, if those items go up, so will your total monthly housing payment. The disadvantage to fixed rate mortgages is that the monthly payment is typically higher than adjustable rate mortgages. Some fixed-rate mortgages you will probably hear about are:

• 30 year fixed rate mortgages
• 20 year fixed rate mortgages
• 15 year fixed rate mortgages

The shorter the term of a fixed rate loan, the lower the interest rate. However, because fixed rate loans are fully amortizing, the shorter the term, the higher the monthly payment is because the loan principal is paid back at a faster rate. The 30 year fixed rate loan is the traditional favorite because it offers an attractive combination of lower principal amortization payments as well as a fixed rate of interest. Some lenders offer 10,25, and even 40-year term mortgages as well. Remember, the longer the term of the loan, the more total interest you will pay but the lower the monthly principal repayment.

The 15-year fixed-rate mortgage allows homeowners to own their homes free and clear in half the time and for less than half the total interest costs of the traditional 30 fixed rate loan. The loan's term is shortened by the 10 percent to 15 percent higher monthly payments. Some home buyers prefer this mortgage because they will own their home free and clear before retirement and probable declines in income.

Adjustable Rate Mortgages

Adjustable Rate Mortgages (ARMs) are one of the most popular and effective tools for helping some prospective home buyers achieve their dream of home ownership. Developed during a time of high interest rates that kept many people out of the housing market, the ARM offers lower initial rates by sharing the future risk of higher rates between borrower and lender. The interest rate is fixed for a initial period of time, usually 1, 3 or 5 years. After the initial fixed period, the loan adjusts based on a formula agreed at the time of closing. The frequency of adjustments is also specified in the original loan documents. Adjustable rate loans typically adjust every six months or every year. The formula contains a margin that is added to a base index that is published regularly in the financial press.

ARMs can be an excellent choice of financing. First, adjustable rate mortgages are attractive during periods of declining interest rates or when rates are expected to stay low. In addition, if you only plan to stay in your home for a limited period of time, it may be worth considering an adjustable rate mortgage to "match" the period of your expected ownership with the fixed rate period on the loan.

Each ARM has four basic components:

• Initial interest rate , which is typically one to three percentage points lower than that of most fixed-rate mortgages. Lower interest rates also make ARMs somewhat easier to qualify for. The initial interest rate is tied to certain economic indicators that dictate in part what the monthly payments will be.
• Adjustment interval , the time between changes in the interest rate and/or monthly payment will be.
• Index , against which lenders measure the difference between what they are making on their investment in the mortgage and what they could be making on other types of investments. The most popular index is based on the rate of return on a one- year Treasury bill (also called T-bill).
• Margin , the additional amount the lender adds to the index to establish the adjusted interest rate on an ARM. The margin is usually 1.5 percent to 2.5 percent.

It is the index plus the margin that will determine what the interest rate will eventually be. Commonly used indexes include:

Treasury Bills. The weekly average yield on U.S. Treasury securities adjusted to a constant maturity of 1 year. It is based on the interest rate that the government pays on some of its debt. This index is used on the majority of ARM loans.

Twelve Month Moving Average. Twelve month moving average of the average monthly yield on U.S. Treasury securities (adjusted to a constant maturity of one year. Because the index calculation is an average of an average, it is less volatile.

Certificates of Deposit. The weekly average of secondary market interest rates on 6-month negotiable certificates of deposit. They are interest bearing bank investments that will lock your savings rate in for a specific period of time. ARM loans tied to this index are usually tied to the average interest rate banks are paying on 6-month CD's. Since this index is tied to bank CD's you can expect this index to adjust a bit more slowly on rising interest rates. They also tend to come down quickly when rates decline because banks do not want to pay higher interest unnecessarily.

Cost of Funds Index. This index is also known as COFI (pronounced just like a cup of coffee). It is published monthly by the Federal Home Loan Bank Board. The index shows the monthly weighted average cost of savings, borrowings, and advances, for member banks in California, Arizona, and Nevada (the 11 th District). Because COFI is a moving average of rates that bankers have paid depositors in recent months it tends to be more stable. This means that the index will increase more slowly when rates are going up. It will also decrease more slowly when rates are going down.

Libor. This is the London Interbank Offered Rate index. It is an average of the interest rates that major international banks charge each other to borrow U.S. dollars in the London money market. These rates are available in 1, 3, 6, and 12 month terms. The index used, and the source of the index will vary by lender. Common sources are the Wall Street Journal and Fannie Mae. The interest rate on many LIBOR indexed ARM loans are adjusted every 6 months.

Margin. The margin is the markup that lenders charge on the money they are lending. It is usually somewhere around 2.75%. The margin does not change during the life of the loan. If your lender offers you various margins, you should consider the lower margin since it will have an impact on how much your rate will increase during the loan term. It is the index plus the margin that gives you the fully indexed rate. This is the rate that your loan should actually be at according to current market conditions.

Adjustments. It is important to find out how often the particular adjustable rate mortgage loan you are looking at will adjust. Adjustments are usually every 6 or 12 months. The lender must inform you before your interest rate is about to adjust. There are usually limits built into the loan as to how much the rate can increase at any one time. These limits are known as periodic rate caps. When shopping for an ARM loan always find out how often the loan will adjust, and what the interest rate caps are.

Periodic Adjustable Rate Cap. There are two types of rate caps. There is the periodic adjustment cap and the lifetime cap. The periodic adjustable rate cap limits the maximum rate change, up or down, allowed for each adjustment. If your ARM adjusts every 6 months, the periodic cap is usually 1% (one percentage point above your current rate). If your ARM adjusts every 12 months the periodic cap is usually 2%.

Lifetime Cap. You should never take an ARM without a lifetime cap. This cap limits the maximum amount the interest rate can adjust over the life of the loan. ARM loans usually have a lifetime cap of 5% to 6% above the start rate of the loan. When deciding on an ARM loan always figure your payment at the maximum rate. This way you will know in advance the very worst-case interest rate for your loan.

Conventional Loans

The term conventional loan refers to loans that are not sponsored by government programs such as FHA loans and VA loans. Conventional loans are both fixed rate and adjustable rate and come with a variety of features. Two government sponsored entities, Fannie Mae and Freddie Mac, buy and sell conventional loans from lenders and provide vitally needed funds available for prospective home buyers to complete their home purchase at reasonable interest rates. There are limits to the size of loans that fannie mae and freddie mac can purchase. Conforming loans are loans are loans that are less than the fannie mae and freddie mac loan limits. Jumbo loans are loans that exceed those limits. As a result, capital available for jumbo loans is not as robust as that for conforming loan. This is why jumbo loans come at higher interest rates than conforming loans.

Interest Only Loans

Interest only mortgages are designed to minimize the required monthly payment. They require that the borrower pay only the interest th accrued during the month and no prinicipal amortization payment. This can significantly reduce the required on a mortgage. For example, the interest only payment on a 30 year mortgage in the amount of $300,000 at a note rate of 5.0% would be $1,250 compared to a full amortizing payment of $1,610. the interest only period is usually for initial term (usually 3 to 5 years) at the beginning of the loan. After the initial interest only period, the loan becomes fully amortizing over its remaining life. At that point, the minimum payment increases significantly. In the above example, assuming the interest only period was 5 years, the monthly payment would increase to $1,754 over the remaining 25 years. If the borrower did not want to bear the higher payment, he would need to refinance the loan. Interest only loans are reserved for home buyers who put down more than 10%. In addition, lenders typically reserve these loans for those with very strong credit reports and credit scores.

Prepayment Penalty

Some lenders offer loans which limit your right to payoff the loan for a period of time in exchange for a lower interest rate. These so called "prepayment penalties" typically cause the borrower to pay an extra amount of money above the loan principal to pay off the loan. Prepayment penalties come in various forms. For example, some prepayment penalties apply in the event that you are keeping the house but just refinacing the mortgage. These are referred to as "soft" prepayment penalties. Prepayment penalties that are triggered even in the event that the home is sold are referred to as "hard" prepayment penalties. The period of time that prepayment penalties are in effect vary but typically they last between 1 and 5 years. The amount of the penalty varies as well. It is not unusual for a prepayment penalty to be as high as 2% of the remaining loan amount.

Mortgage Insurance

In situations where the borrower applies for a loan that is greater than 80% of the purchase price (in otherwords, he makes a downpayment of less than 20% of the purchase price), the lender will require that he pay for mortgage insurance. Mortgage insurance provides financial protection to the lender in the event that the lender is required to foreclose on the loan. Mortgage insurance would reimburse the lender if the property for losses sustained in the event that the property sells for less than the amount of the mortgage it secures at the foreclosure sale.

The cost of mortgage insurance varies by loan type, property type and the amount of downpayment. The premium can be as much as 1.0% of the loan amount annually. In addition, mortgage insurance premiums are not tax deductible like interest payments.

In some cases, it may be possible to avoid paying mortgage insurance by structuring the purchase with two loans. The first mortgage is done at 80% of the purchase price and the second mortgage is down for the balance of the required proceeds. Such loans are referred to as "80/10/10" loans (the 80 refers to the percent of the first mortgage of the purchase price, the 10 refers to the percent of the second mortgage of the purchase price and the remaining 10 refers to the amount of the downpayment as a percent of the purchase price). In most cases, the second mortgage is a home equity line tied to the prime rate. These types of structures also exist in 80/15/5 and 80/20/0. Usually, structuring a purchase in this manner can save the borrower a significant amount of money in mortgage insurance premiums. However, is typically assuming interest rate risk since the interest rate on the home equity loan typically adjusts monthly with the prime rate.