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Types of Mortgage Financing

The two most prevalent types of mortgage financing are fixed rate loans and adjustable rate loans (ARMs). There are variations of both types, such as temporary buydowns, negative amortization ARMs, and 3/1, 5/1 & 7/1 ARMs, commonly knows as mid-range ARMs or "blends."

Fixed Rate Mortgages
This loan has a rate that is "fixed" for the entire term of the loan. The principal and interest payment will not change during its life, regardless of whether the loan is paid on a normal amortization basis or accelerated (prepaid).

Adjustable Rate Mortgages
This type of mortgage has a rate that will "adjust" (increase or decrease) at a predetermined interval of time, such as 6 months, 1 year, 3 years, etc. These loans are tied to a specific "index," and it is the fluctuation of this index that dictates the direction and amount of interest rate change. ARMs also have per adjustment period and lifetime caps that serve to limit the amount of rate and payment change. Some ARMs allow the customer to qualify at the start rate, which increases borrowing capacity, and other ARMs require the customer to qualify at the first maximum adjustment cap. Below are terms and definitions associated with ARMs, along with an example.

• Index
  The most commonly used index associated with ARMs is the "Treasury Securities Index," better known as the "T-Bill." There are ARMs available that are tied to the T-Bill, having various maturities such as 1 month, 6 months, 1 year, 3 years, etc.
  • COFI - this index is the 11th District Cost of Funds. COFI is the cost of money (interest rate) that banks who are members of the Federal Home Loan Bank Board charge each other for overnight loans.

  • LIBOR - this index is the London Interbank Offered Rate. This rate is what the most creditworthy international banks dealing in Eurodollars charge each other for large loans.

  • PRIME - this is the rate that banks charge to their most creditworthy customers.
    
    
• Margin
  The margin, or spread, is the premium added to the index at the time of adjustment to determine a loan's "fully-indexed" rate. This margin represents a lender's potential gain, or the difference between the yield and actual cost of funds.
  
  
• Cap
  The cap is the maximum amount (defined as a percentage) that an ARM can increase or decrease for any given adjustment period. Most ARMs will have a per adjustment period cap and a lifetime cap. In addition, a "floor" cap is stated on the note. The per adjustment cap usually ranges from 1 to 2%, and most life caps range from 4 to 6%.

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