Fixed rate mortgages are the most popular financing instruments because they combine the safety of fixed payments with affordable amortization for the term of the loan. The interest rate cannot change and because of their wide availability, rates offered by various lenders are extremely comparable and competitive.
One area in which fixed rate mortgages vary is their term, the length of time over which the payments are due. The two most common terms are the 30 year term (360 payments) and the 15 year term (180 payments). The tradeoff between the two is that while the latter has payments that are roughly 50% higher the total interest paid over the life of the loan is hundreds of thousands less because the money being lent is for half the time of the former. The obvious benefit is that one’s debt is being retired in half the time. These loans also have a lower interest rate because of the diminished inflation risk due to the shorter term. The downside is that most borrowers cannot afford the increased payments that go with a 15 year term unless the loan amount is rather small. Thus, most people opt for a 30 year term. One benefit of a 30 year term (albeit at the expense of paying more interest) is that provides more tax shelter for borrowers.
The 30 year and 15 year terms are by no means the only term options open to a borrower. Loan terms can be customized to the borrowers needs. For instance, 25, 20 and 10 year loans are available, as well. While some lenders place restrictions on the terms offered, these loans are sold in the secondary market just like most other loans. One restriction is that the interest rate for such a loan is likely to be determined by the longest loan term. Therefore, a 25 year loan is apt to have the same rate as 30 year loan and a 10 year term may have the same rate as a 15 year loan. Currently, Fannie Mae offers 10 & 20-year pricing.
As fixed rate mortgages go, they’re pretty straightforward—“what you see is what you get”. But there are borrowers whose needs are not met by a fixed rate loan. To serve this segment, a creative “hybrid” fixed rate loan that provides a solution is the balloon mortgage. The payments are fixed for essentially the life of the loan with the exception of a much larger final payment or balloon payment at the end of year 5, 10, or 15. This final payment may also be referred to as a “call” or “demand” payment. A very common example of just such a loan is 30 due in 15 which means that the amortization is based on 30 years but the balloon payment is due at the end of 15 years. The advantage of these loans is that the payments are lower since they are amortized over a longer time frame.
Some of these loans have a feature that converts the loan to a fixed rate loan after the balloon; this is called a “conditional refinance”. It is important that borrowers understand that a balloon is not an ARM (adjustable rate mortgage) and that a conditional offer to refinance at maturity does not guarantee financing. To be eligible for a conditional refinance, most loan programs require the following:
· Must be owner occupied property
· No 2nd mortgages or liens
· Must be current/No late payments in the past 12 months
· New rate cannot be more than 5% above the note rate
· Borrower must pay refinance fees/sign documents
TWO STEP ARM
Like a balloon, this loan offers a fixed rate for a fixed period that is lower than comparable 30 year fixed rate loans. This loan has no balloon feature, instead there is a rate adjustment at the end of the fixed rate period converting the loan to an ARM instrument. The terms of the adjustment may vary, but the margin is generally 2.5% over the prevailing rate on the 10 year Treasury Bill or an index like the CMT (constant maturity index) with a maximum change or rate cap of 6%.
Because the Balloon and the Two Step are similar people often get them confused. The Two Step is actually a 30 year ARM loan whereas the Balloon expires on the loan’s call date. Because there is no protection for the borrower after the “call” or “demand” payment the lender’s risk of future interest rate changes is diminished, hence in this rare instance fixed-rate balloons offer much lower interest rates than a Two Step ARM.
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