If you decide to purchase a home then you need to understand what type of mortgage works best. There are two types of interest structures associated with a home mortgage: fixed or adjustable.
Fixed interest rates are locked and remain the same for the term of the repayment period. The principal (the main sum of money borrowed) and the interest payments do not change during the term of the mortgage. These types of mortgages are typically 15 or 30 years in length.
Fixed interest rates tend to be higher than adjustable-rate mortgages because the interest rate risk (the risk that interest rates will rise or fall during the life of the loan) is borne by the lender. The idea behind interest rate risk is that there is a risk of losing money as interest rates change. For example, if a buyer gets a fixed-rate mortgage at 4.5 percent interest, that buyer would effectively be losing money if interest rates then dropped to 3.5 percent. Conversely, the lender would be losing money if interest rates rose to 5.5 percent.
An adjustable-rate mortgage (ARM), also known as variable-rate mortgage or floating-rate mortgage, allows for adjustments of the loan interest rate at pre-specified regular intervals.
Adjustable interest rates fluctuate with interest rates in the overall economy. As interest rates vary, the adjustable interest rate and principal payments change. However, there are no limits as to how frequently the rates may change or how high they may become. Adjustable-rate mortgages generally carry a lower initial interest rate than fixed mortgages because the interest rate risk is borne by the borrower.
The following are components of an adjustable-rate mortgage:
- Initial rate is the initial interest rate charged on an ARM for a specified period of time, which may be anywhere from three months to 10 years. The shorter the initial rate period, the lower the initial rate is because more of the interest rate risk is shifted to the borrower.
- Interest rate index is an index used to calculate the interest rate for an ARM, independent of the lender. As the index rises or falls, the interest rate for the ARM also rises and falls. Some common indexes include the interest rates for the 6- or 12-months government securities or the prime rate.
- Margin is the number of percentage points added to an interest rate index to determine the current ARM rate.
This is calculated as follows:-
ARM rate = index rate + margin.
For example, if the index rate is 5 percent and the margin is 2 percent, then the ARM rate is 7 percent.
- Adjustment interval determines how often the ARM rate will be reset. A one-year adjustment interval is most common.
- Rate cap is the limit on how much an ARM rate can change.
- Periodic cap limits how much the rate can change at a given adjustment interval.
- Lifetime cap limits the total rate adjustment during the life of a loan.
- Payment cap establishes a dollar limit on how much a monthly payment can increase.
- Negative amortization is a potential situation in which monthly payments are not enough to cover interest due on the loan. Unpaid interest is then added to the loan balance. This causes the borrower’s principal balance to increase each month rather than decrease.