Simply put, a mortgage is a loan you get to buy a house. Since it is likely to be the biggest loan you’ll ever get by far, it’s a good idea to understand how they work.

Mortgages are considered to be fairly low risk investments because the loan is backed (or collateralized) by the house. If you stop making payments, the bank gets the house through a process called foreclosure. This is why the interest rates offered on mortgages are much lower than other types of loans (if you don’t believe me, try to get a 6% interest rate on a credit card over the long term).
 
There are as many types of mortgages as there are ways to order a Starbucks latte. However for the majority of homebuyers, the mortgage selection process boils down to two key choices: Fixed-Rate Mortgage (FRM) or Adjustable-Rate Mortgage (ARM). As the names imply, a fixed-rate mortgage is one where the interest rate paid on the loan will be constant throughout the life of the mortgage. Similarly an adjustable-rate mortgage is one where the rate will be fixed for some introductory period (which could be anywhere from 6 months up to 10 years) and then can be adjusted upwards on a periodic basis from then on. As you might imagine, the initial interest rate on an ARM will generally be lower than that of a fixed-rate mortgage, but then can creep steadily higher after the introductory period is over.

Understanding the ARM
The ARM can be intimidatingly confusing, and many people who are drawn to the initially low rates of the ARM have found themselves unpleasantly surprised by unexpected payment hikes in later years. Thus it is important to understand how the ARM works and thus how the payments can change over time.

Most ARMs start out with an initial period with a fixed interest rate. After the initial period is over, the new interest rate is typically based on an interest rate index plus an additional margin of 2-3%. The new rate can be adjusted periodically (typically once a year) based on the current interest rate index that the ARM is based upon. However typically these interest rate adjustments are limited by: the interest rate cap, which imposes a limit on the size of any interest rate increase, and the maximum allowable rate on the contract. This means that even though the ARM interest rate will be recalculated annually, in any given year it can’t increase more than the rate cap, and it can never go above the maximum allowable rate (although the maximum rate can be as much as 5-6% higher than the initial fixed rate). 
 
ARMs are usually followed by two numbers, such as 5/1. The first number represents the number of years in the initial period which has a fixed interest rate. The second number indicates how frequently (in years) the interest rate can be adjusted once the initial period has ended.

Example ARM Scenario:
3/1 ARM with a 30-year term
Initial interest rate: 4.5%, adjustable rate is based on LIBOR (one of several interest rate indices used) + 2%, with a rate cap of 1% and a maximum rate of 11%.
Loan Amount = $100,000

The worst- case scenario for this mortgage would be an 11% interest rate resulting in a monthly mortgage payment of $945, or almost double the payments during the initial period.

In addition to the traditional FRM and ARM, there is a less frequently used mortgage called the balloon Loan. Balloon loan payments are calculated the same way as that for a 30-year FRM. The difference is that at end of a fixed period (either 5 or 7 years) the outstanding balance of the loan (or the balloon) must be repaid in full. Thus the borrower would either need to sell the house before the period ended, or refinance. Balloon loans tend to have a lower interest rate than an ARM with a similar (5 or 7 years) initial period.

For the FRM and ARM mortgages, the next decision is how many years you want to have to repay the loan, typically either 10, 15, 20, 25, or 30 years. The shorter the term of the mortgage (meaning the fewer years till it is paid off), the lower the interest rate on the loan. Additionally, since you are paying the principal back more rapidly, the shorter-term mortgage will result in significantly less interest expense than a longer-term mortgage. However shorter-term mortgages tend to have much higher monthly payments, which is why most buyers go with the most common 30-year term mortgage.

The real complexity in mortgages tends to come from the options that can be added to the basic FRM and ARM. These are briefly outlined below:

Interest-only Option-
Most mortgages are fully amortized, which means that part of the monthly payment is used to reduce the outstanding balance of the loan. An interest-only option enables the borrower to reduce their monthly payments (usually for 5 to 10 years) by paying just the interest on the loan, and thus not reducing the outstanding balance. A mortgage with a interest-only option will almost always have a higher interest rate than an identical mortgage without the interest-only option.

Option ARM-
The so-called option ARM (also called “pay-option”) is most commonly used with ARMs (hence the name) but can also be applied to a FRM. It is a mortgage where the borrower has a choice of monthly payment options which may include a low minimum payment, interest-only payment, 15-year or 30-year payment. The option ARM has become popular in recent years due to the fact that borrowers can significantly lower their monthly expenses by selecting to make only the minimum payment. According to Fitch Ratings, 80% of option ARM borrowers make only the minimum monthly payment.

The option ARM is a fairly risky alternative. The terms of an option ARM are generally complex which can make comparing them to other mortgages challenging. Most offer a very low initial “teaser” interest rate which can leave borrowers unprepared when the initial period ends and the rate jumps upward.

Additionally, while most borrowers make only the minimum payment each month, many do not realize that this payment results in negative amortization. This means that they are actually increasing the amount of their loan each month. This loan vehicle does offer useful flexibility for folks with variable income streams though (budding actors and rock stars ;-)

As an example of how this can occur, assume you have a mortgage loan for $100,000 with an interest rate of 6% on which you make only the minimum monthly payment:

Thus at the end of 1 year of making the minimum payment, you would owe the bank $2,042 more than you did when you took out the mortgage. To add insult to injury, when the interest rate resets on this loan, you would end up paying a higher rate on what is now a larger loan than you started out with.

Continue Reading - Mortgages 101 - Part II

Additional Resources:

Mortgages 101 - Part II

Mortgage Professor

Mortgage Calculators

ARM Indices

Mortgage Articles