Mortgages Pay Your House Over Time
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Mortgages Pay Your House Over Time

Mortgages are a way of paying your home loan off over time. Technically, "to mortgage" means to agree to give something up if you fail to perform some action. The word actually comes from an Old French root, meaning "death pledge", since mort means "death" in French.

So it’s serious. A mortgage lender is not going to just hand you a blank check to buy the house of your dreams and hope to get the money back. The mortgage lender is going to check you out. Thoroughly.

What kind of mortgage should you get? The traditional vehicle was a 30-year, fixed rate loan with a 20% down payment. For those who could afford higher payments, a 15-year loan was available, still with 20% of the purchase price as the down payment. Add to that the costs for closing your loan, and a mortgage can get expensive even before the first payment!

Because people sometimes couldn’t scrape together enough money for a large down payment, loan programs were developed that required smaller amounts. The Federal Housing Administration started issuing FHA loans in 1934 that required as little as 3% down. FHA loans are still a popular option today.

In 1944 the Veteran’s Administration began guaranteeing home loans to members of the military returning from World War II. These VA home loans might require no down payment at all, and the seller even paid some of the closing costs! This new option allowed thousands of people to buy a home who otherwise would not have qualified.

FHA and VA loans are still around today, and are a great option for many people. For lenders, though, they pose a fair amount of interest-rate risk. If the lender makes a loan at six percent, and then their own cost of funds rises beyond that, the lender can’t borrow money for new loans at a profitable rate. Lenders’ cost of funds is usually tied to an interest rate index.

Because of that, adjustable rate mortgages (ARMs) came about. Also called variable-rate mortgages, interest rates on these instruments re-sets periodically based on the rate the lender pays for funds.

Some of the more common indeces to which rates are tied include the 12-month Treasury average, the 11th District Cost of Funds, or National Average Contract Mortgage rate.

With an adjustable rate mortgage, when rates change, so does the borrower’s payments, or sometimes the term of the mortgage. Adjustable rates are particularly attractive when rates are high, as the odds are that the instrument will re-set in a downward direction. Also, banks do not charge as much for their own profit margin on the mortgage, as they carry a much smaller interest-rate risk than they do on a fixed-rate instrument.

However, as the recent mortgage crises brought to light, some borrowers may not be prepared if the rate rises too much. Typical ARMs adjust at 1-, 3- or 5-year periods, although there are quite a few variations on that theme. There are also limitations on how much the loan can rise at the first interest rate adjustment (Initial Adjustment Rate Cap), at each subsequent change (Rate Adjustment Cap), and over the lifetime of the loan (Lifetime Cap).

Adjustable Rate Mortgages come in many variations, but the one constant is change. As a borrower, you need to be aware of those changes, how much they could be, and how they could impact your household budget. ARMs are a tool, and like any tool they can be a great help when used wisely, but can also hurt you if not used with care.
 

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