Different Types of Interest Rates and Loan Terms – A Guide

Adjustable-Rate Mortgages

An adjustable-rate mortgage (ARM) is a loan in which the interest rate can change, based on the prime rate or index rate, over the course of the loan. After the fixed-rate period, the interest rate of an ARM may change monthly or annually, depending on the market index. A mortgage provider might also place a cap on the maximum interest you’ll need to pay.

With an ARM, part of the interest rate risk shifts from the lender to the borrower. As a result, borrowers commonly use ARMs in situations where fixed-rate alternatives are prohibitively expensive or difficult to obtain.

While a majority of lenders in the U.S. use the United States Treasury rate as a basis to determine the interest rates of most ARMs, some rely on the London Interbank Offered Rate (LIBOR).

Different Types of Adjustable Rate Mortgages

Adjustable mortgages for home purchase come in three basic forms that include conventional variable rate mortgages, hybrid ARMs, and option ARMs.

Conventional Variable Rate Mortgages

Getting a typical ARM requires that you prepare yourself for adjusting rates for as long as you do not repay or refinance the mortgage. The rate usually reflects a third-party index, and includes the margin a mortgage provider applies. Rates adjust based on a predetermined schedule, which can be monthly, every six months, or every year.

Hybrid ARMs

Hybrid ARMs, also referred to as fixed-period ARMs, come with a fixed rate for a specific period of time, and an adjustable rate follows. The fixed-rate periods may vary from three (3/1) to five (5/1) to seven (7/1) to even 10 (10/1) years. When the initial fixed-rate period is long, the difference between the interest rate of an ARM and that of a fixed-rate mortgage is small. The converse holds true as well.

The date when the switch takes place is the reset date. Then, the interest rate is assessed and recalculated every year. Some ARMs, such as 3/3 and 5/5 ARMs, come with more than one interest rate adjustment per year. However, these are not easy to find.

Option ARMs

If you go the option ARM way, you get to choose from four monthly payment alternatives. These include a predetermined minimum payment, a 15-year amortizing payment, a 30-year amortizing payment, or an interest-only payment.

What Attracts Borrowers to Adjustable Rate Mortgages?

Most people who benefit from getting ARMs plan to sell their homes in a few years or ones who plan to refinance their mortgages down the line. This is because the longer you plan to draw out an ARM, the riskier it can get. After all, while the interest rate is typically low when you start, it can get noticeably higher once rate adjustments begin. An example in case is the period during the subprime crisis. After rates began to adjust, several borrowers with ARMs found that their monthly payments increased drastically.

How Do Cap Limit Adjustments Work?

Several ARMs come with cap limits on adjustments. This ensures that the interest you need to pay through the course of the loan will not exceed a predetermined mark. For example, if your mortgage comes with a two percent cap, and market rates increase by three percent, the interest rate on your mortgage will increase only by two percent. ARMs can come with caps for the first few years, periodic caps, as well as lifetime caps.

Consider a 3/1 ARM that comes with a cap limit structure of 2-3-7. What this basically means is the interest rate can increase by a maximum of 2% after the initial three-year fixed-rate period. In subsequent years, the rate may increase by a further 3% every year. The maximum interest rate hike that a loan may attract during the entire loan term, in this case, limits to 7%.

In case you start with an initial interest rate of 4.1% for the first three years, the interest rate in the fourth year can increase to a maximum of 6.1%. In the fifth year, it may increase by up to 3%, getting to no more than 9.1%. Going forward, the interest cannot increase to more than 11.1%, which is 7% more than the loan’s original interest rate.

The cap works in reducing your risk slightly. However, the difference in monthly payments can be noticeable in some instances. For example, if you take a $200,000 ARM at 4%, and the interest rate increases to 10%, your monthly mortgage payment would increase by around $800. Just how much the rate adjusts depends on the ARM’s index rate.

Should You Get a Fixed- or Adjustable-Rate Mortgage?

Various aspects require your attention when determining if a fixed or adjustable-rate mortgage might work better for you.

Interest Rate Prediction

Since the 1990s, interest rates have decreased gradually, although there have been periods of movement in both directions. However, one should not take historical trends for granted when it comes to predicting future performance. Besides, predicting the timing, direction, and speed of adjustments is not easy, especially when it comes to getting all three right.

When existing interest rates are low and there is speculation about a hike, opting for a fixed-rate mortgage might be the way to go. This is because the low interest rate will stay in place even if the market rate climbs to a higher level. However, if there are predictions that interest rates might fall, you may want to consider getting a mortgage with an interest rate that fluctuates over time as market rates change.

The Certainty Factor

If you are already on a tight budget, you don’t want to worry about unfavorable changes in interest rates denting your ability to make timely repayments. In such a scenario, while a fixed-rate mortgage would come with higher monthly payments initially, it would offer peace of mind down the road, with you knowing that your repayments will not change through the loan term.

Making Prepayments

If you plan to make aggressive prepayments to try and pay your mortgage off ahead of time, you can benefit by getting an ARM. This is because if you manage to pay a significant portion of the loan during the fixed-rate period, interest rate hikes in the later stage might not have too much of a negative effect on an already reduced loan balance.

Time Period

People who plan to repay or refinance their mortgages in short timeframes tend to favor ARMs over fixed-rate alternatives. For instance, a borrower who intends to keep a loan for around six to eight years might be comfortable taking an ARM that is set to adjust in five or seven years.

Amortization Period

Your amortization schedule will give you a clear indication of your periodic loan payments. In it, you get to see just how much of the payment you make each month goes toward reducing the principal amount and paying off the interest. With a long amortization period linked to an ARM, changing interest rates can have a considerable impact on your monthly payments. This is not the case with fixed-rate mortgages, where your payments remain the same throughout.

The bottom line is that getting an adjustable-rate mortgage might work well for you in a decreasing interest rate environment. However, the flip side is that any rise in interest rates will translate into higher monthly repayments. Keep in mind that many borrowers could not keep up with their rising payments because of steep interest rate resets during the 2007-2009 Great Recession.

What’s an Interest-Only Mortgage?

An interest-only mortgage gives you the option of making considerably low monthly payments for a predetermined time period, where the payments you make only go toward the interest that your loan attracts. Once the introductory period ends, you will need to start making payments toward the principal, which would be more than it would through a conventional fixed-rate mortgage.

In the long run, interest-only mortgages turn out to be more expensive. However, such mortgages might work well for first-time homebuyers who expect their careers to improve soon as well as for individuals who have limited resources at first.

What Is a Loan’s Term?

A loan’s term refers to the time you get to repay the loan in full, including the principal amount and the interest it attracts. Loan terms are typically easy to identify. For example, a fixed-rate 30-year loan requires that you repay it completely within 30 years.

The term of a loan has a bearing on how much it ends up costing, because it affects the interest you pay directly. The relationship is simple; the longer the loan term, the more you pay as interest. So, while a longer loan term might seem tempting because it comes with lower monthly payments, you’ll end up paying more in the form of interest. The reverse holds true as well.

As a result, you’ll end up paying considerably more through a 30-year mortgage when compared to a 15-year mortgage. The question is – how much can you afford to repay each month?

Common Loan Terms

• 30-year mortgages. A large majority of borrowers opt for 30-year mortgages, making it the most common loan term. This is probably because long loan terms reduce the financial burden of home ownership, and it also gives borrowers the ability to buy more expensive homes.
• 20-year mortgages. If you get a 20-year mortgage, not only do you pay your loan off sooner, but you end up saving a tidy sum in the form of interest. The interest rate you get will also be slightly lower than that of a 30-year mortgage.
• 15-year mortgages. These mortgages come with the most competitive interest rates. This ensures that your repayments are not twice as much as they would be through a 30-year mortgage. In addition, the reduced loan term means you end up paying considerably lesser as interest in dollar value.

What Are Combination Mortgages?

If you cannot make a 20% down payment and want to avoid paying private mortgage insurance (PMI), consider taking a look at how combination mortgages work. Typically, you would take one loan to cover 80% of the home’s value, and another to cover the remaining 20%. The mortgage industry refers to this as an 80/20 combination loan.

In such a scenario, the first loan for the higher amount usually has a lower fixed rate, whereas the second loan comes with a higher and/or variable rate. Depending on how quickly you expect to repay the second loan, you might be better off getting a combination loan instead of PMI. However, you must do your math in advance.

Conclusion

The interest rate attached to your mortgage and the loan’s term can have a telling effect on how much you end up paying over time. If you get an ARM, in which the interest rate may fluctuate up or down during the term of the loan, a hike in rates may affect your ability to make timely repayments. Fixed-rate mortgages, on the other hand, are the safer approach to home ownership. To determine which type of interest and what loan term might work well for you, take your existing and predicted financial situation into account while talking to your loan officer, and don’t forget to factor in contingencies.