Before applying for a mortgage, whether for a new home loan or to refinance, learn about the 2 basic types of mortgages you will be asked to choose from:

1. Fixed Rate Mortgages
2. Adjustable Rate Mortgages

Fixed rate mortgages, as the name suggests, as a fixed rate of interest applied to the principal amount of the mortgage and does not change over the life of the loan.  The life of the loan, usually 15 or 30 years, is also fixed.

However, Adjustable rate mortgages or “ARM’s”, as indicated by the name, has payments (principal plus interest) that adjust or change with direct correlation to changes in the existing prime rate, US Treasury bills, certificates of deposits (CD’s), the Cost of Funds Index (COFI)during the life of the loan.  However, there are limits, as specified in the terms of the loan, as to how much that payment can change during the life of the loan.  Many have a cap of 2-3 percentage points change during a year with a lifetime cap of 6 to 8 percent.

Furthermore, as the financial markets and prime rates change, so too does the climate of the lending industry. It is very important to consider these possible changes and how they would affect your ability to repay during the life of the loan. It is advisable to create 3 financial scenarios of the life of the mortgage before approaching a mortgage company. This will be your litmus test to know if you should or should not apply for a particular loan amount. It may seem tedious, but worth the time in the end. For the purposes of this exercise, we will leave out the possibly winning of the lottery.

1. Average Scenario:

   Expected monthly income and average expected monthly expenses

2. Less Than Average Scenario:

   20% lower than above expected average income and 10% higher than expected expenses (plus cost of living increases of 4% added to each year’s expense estimates

3. Worst Case Scenario:

   6 Months unemployment with no income and cost of living adjustments of about 5% added each year to your expected expenses

Having gone through these scenarios before you begin house hunting, you will be well equipped to look for the appropriately priced home. Also, when approaching a lender, you will not only understand the risks of the ARM’s, but also understand if you could withstand the increases in a monthly mortgage payment if there are any unforeseen financial setbacks during the life of the loan. Remember, establish a credit history and pay your bills on time. That way, the lender knows that you are not a financial risk, but a great customer to have.

No related posts.