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You can select one of two basic options when applying for a mortgage:
1. Adjustable Rate Mortgage (ARM)
2. Fixed Rate Mortgage (FRM)
Fixed rate mortgages are mortgage loans with a fixed interest rate and term. The term, or life of the loan, is normally 15 or 30 years. The interest rate is applied to the amount of the loan, or principal. Since the rate is fixed, it never changes during the entire term of the loan.
Mortgages with interest rates that are not fixed are called "adjustable rate mortgages," or ARMs. The rate changes track changes in the prime rate, U.S. Treasury bills, certificates of deposit (also called CDs) or the Cost of Funds Index (also referred to as "COFI"). There are floor and ceiling limits placed on these changes, however, which will be specified in the terms of the mortgage. Commonly, mortgages can only change 2-3 percentage points each year, with a lifetime cap of 6 to 8 percentage points over the life of the loan.
Conditions in the lending industry change as the prime rates and financial markets that they rely on change. Thus, it is vital to consider aforementioned changes and how they would change your ability to repay the loan over its lifetime. You can do this by devising three financial scenarios and how they would affect you during the life of the loan before visiting a mortgage company to actually apply for the loan. By doing this, you will be able to gage if you should really apply for a particular loan amount. This is a very important step to take when considering a loan. For the following examples, we will not consider winning the lottery as a viable financial scenario.
1. Usual Scenario:
Projected monthly income and average projected monthly expenses
2. Worse than Usual Scenario:
20% less than projected average income and 10% above projected expenses (with cost of living increase a 4% added to yearly expense estimate).
3. Worst Possible Scenario:
No earnings, 6 Months of unemployment, add 5% cost of living increase to projected yearly expenses.
Going through the task of laying out several different scenarios, you will be well prepared to look for a home that is priced right for you. You will also be able to apply for mortgages understanding the risks in taking out an ARM, and knowing whether you are prepared for any future adverse circumstances. And always remember to pay your bills on time and establish yourself as a low credit risk. Make yourself into a desirable customer, and lenders will want your business.
Ron Finkelstein is NOT a Real Estate Attorney, Accountant or Mortgage Broker. He is merely a small business owner who has paid a lot of money over the years to learn a whole lot about Fixed Rate Home Loans vs ARMs - You should also learn about:
The Mortgage-Refinancing Question and Interest Only Mortgages.
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