Loans - Homeowners Biggest Risk

The world of mortgages can be a bit confusing with all the different terminology, jargon and rates. It gets even more interesting when the acronyms come into play – ARM, FRM, RAM, APR, just to name a few.  Stacy Giovaneti asked what is the difference between a 15-year and a 30-year fixed rate mortgage. This is actually a fairly simple answer, but one that brings up a few more complicated possibilities.
There are basically two types of mortgages when it comes to rates – Fixed Rate (FRM) and Adjustable Rate (ARM). A fixed rate mortgage is exactly what it sounds like, a mortgage with a specific interest rate that is set at closing (or when the rate is “locked”) and never varies for the life of the loan.

An adjustable rate mortgage starts at a certain rate and is adjusted periodically as market interest rates change. When it is adjusted depends on the specific terms of the loan. The first adjustment may come after a year or it may come after some other time. 2, 3, 5 and 7 year time frames for the first adjustment are typical. Once the first adjustment happens, the rate can be adjusted again periodically. Annual adjustments are common. There is usually a limit on how much the rate can adjust at one time and often a maximum rate.
ARMS have gotten a lot of bad press recently as rates have started to adjust upward for many borrowers, especially those that took out zero percent “teaser rate” loans. A loan which adjusts annually starting after 1-year and which has a low teaser rate can be very dangerous for the borrower, as the payment can increase substantially in just a couple of years. The longer term adjustments, especially in the 5 to 7 year range for the first adjustment, may be a good deal for many borrowers as the typical US consumer moves roughly every 7 to 10 years and there is plenty of time for saving or increasing income before the first adjustment.

The number of years in a 15-year and 30-year Fixed Rate Mortgage actually refers to the number of years in the loan payoff schedule or “amortization.” If you get a 30-year FRM and make the payments as scheduled, in 30-years the mortgage will be paid off. Get a 15-year FRM and in 15-years it will be paid off.

Adjustable rate mortgages aren’t so simple. A commonly quoted ARM rate is for a “1-year ARM.” If you’re like many people, you may be thinking “How could I pay it off in 1-year?!?!” You don’t. The loan is still amortized over a “normal” loan period – usually 30-years, though 15 is also an option. The “1-year” refers to the time before the first rate adjustment. So, if you see a “7-year ARM with 30-year amortization” or a “7/30 ARM”, you’re seeing a loan that has a fixed rate for the first 7-years and is paid off over a 30-year period. 5/30 – The first adjustment will happen after 5 years and the loan is paid off over a 30-year period. The initial payment on a 1-year ARM with a 30-year amortization will be the same as a 30-year FRM with the same interest rate. In a year if the rate adjusts up, the payment will adjust up to be the same as a fixed rate mortgage with the new higher rate and the same initial payoff
 period/number of payments.

With so many loan products available, the key here is that if you venture outside the relatively simple world of 15-year and 30-year Fixed Rate Mortgages, you need to understand very specifically the terms of the loan you are taking and all possible scenarios for interest rate changes. The sooner the first adjustment happens and the bigger the annual adjustments that are allowed, the more important it is to examine the “worst case” scenarios that may catch you before you’ve saved or built equity.

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