• Terms to Know
• Fixed-Rate Mortgages
• Adjustable-Rate Mortgages

Terms to Know

• Mortgage: a loan for which property, such as a house or and, is used as security for repayment. There are many types of mortages, including loans with different lengths of time, or terms, as well as different interest rates and other special features.

• Down Payment: an initial, larger payment at the beginning of a mortgage. A down payment is required for a mortgage, although it is possible to find differing percentage requirements from different lenders. A larger down payment will reduce the overall loan amount and provide a smaller monthly payment.

• Principal: the portion of the payment that goes toward paying off the loan balance. Each payment is made up of principal and interest.

• Interest Rate: the percentage of the remaining loan amount that is charged each year. This rate, divided by 12 (for monthly payments) is multiplied by the remaining balance on the loan each month todetermine how much of the payment goes toward paying the lender or bank interest and how much of the payment goes toward equity, or paying off the loan principal.

• Equity: the difference between the appraised value of a home and the remaining balance on the mortgage. The portion of payments that goes toward paying principal decreases the remaining balance on the loan and so increases equity. The down payment also increases equity, as it is a single initial payment to reduce the loan balance. In addition, if a home gains value over time, equity will increase.

• Mortgage Insurance: insurance for the lender, to reduce the risk of loss if the borrower defaults on loan payments. This payment is paid by the borrower and usually added to the mortgage payment, until the equity in the home reaches 20% of the home value.

• Points: prepaid interest. Points are a way of paying interest cost upfront. One point is equal to one percent of the loan value. Typically, points are used to "buy" a lower interest rate. By paying interest upfront, the interest rate (and consequently the payment amount) can be lowered for the life of the loan.

• Front-End Ratio: ratio of the mortgage payment to gross monthly income (income before tax). This ratio shows what percentage of monthly income goes toward paying mortgage, including homeowners insurance, taxes, and both parts of the mortgage payment, principal and interest. Many lenders have limits that the front-end ratio must not surpass in order for someone to be approved for a loan.

• Back-End Ratio: ratio of total monthly debt payments to gross monthly income. This ratio shows what percentage of monthly income goes toward paying all debt payments, including child support or alimony payments, as well as student loans and credit card bills.

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Fixed-Rate Mortgages

The most common type of home loan is a 30-year fixed-rate mortgage. Fixed-rate mortgages have been around longer than other types of home loans, and they continue to be popular for several reasons. With this type of mortgage, an interest rate is locked in at the beginning, and it does not change through the life of the loan. The term does not have to be 30 years; there are other options available as well, with the other most common option being 15 years.

One of the advantages of a fixed-rate mortgage is that the payment is constant, throughout the life of the loan. The interest rate can never increase, so the payment can never increase. However, the interest rate cannot decrease either, so if interest rates decrease, someone with a fixed-rate mortgage would be making a higher payment than what might be available in the market. The interest rates in a fixed-rate mortgage typically are higher than the initial rates for adjustable-rate mortgages, but because they are fixed, they will be lower in the long-run. For this reason, this is a popular choice for people who will be living in the same house for a long period of time.

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Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) are not quite as popular as fixed-rate mortgages, and there is some risk involved, but they could be a good option for some. With this type of loan, the interest rate changes as the market changes. There is typically a starting period, during which the interest rate cannot change. After this period, the interest rate adjusts to the market.

An ARM is typically sold as a "n/m" ARM, where n is the number of years for the initial fixed-rate period, and m is the number of years between each adjustment after the initial period is over. For example, a 5/1 ARM means that the interest rate is fixed for the first 5 years, and then it can adjust each year after that.

It seems like an interest rate that could increase every year would always be a bad choice, but there are circumstances in which an adjustable-rate mortage could be a good decision. If someone was only going to be living in a home for a short period of time, and ARM might be great, because they would move out before the initial, fixed-rate period is over. Initial interest rates in ARMs are generally lower than those offered on fixed-rate mortgages. A homeowner could also wait until the end of that adjustment period and then refinance, if the refinance was optimal.

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