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Purchasing a home is the most important decision in the life of most of the individuals. It is important because of the emotional attachment to the property and also because it is by far the biggest financial decision for most of the individuals. The financial impact is bigger than that in taking an education loan or purchasing a car or any other thing for most of the individuals.

This figure shows the distribution of debt in US households. We can see the overwhelming percentage share of mortgage debt in the household. This is, above all, the remaining debts which are generally talked about. The credit card and auto loans are also much lesser than the mortgage debt. Hence, a complete understanding of mortgage scenario is essential to have a complete control over the financial health of the household.

The first thing to determine before going for a mortgage is to determine the monthly payments which are acceptable to the household. It is always better to go for a conservative figure which can easily be met by the household. It is considered that 28% of gross income is the upper limit to be kept for mortgage payments. Hence if a household’s annual income is $60,000, it can pay $16,800/year or $1,400/month. It is advisable to go for a buffer in this and keep the mortgage payments in the range of $1,100 to $1,200 for this household.

The next major question is the type of mortgage payment to use. Following are the major types of mortgage which can be purchased:
Fixed mortgage: Traditionally this was the single most used mortgage by previous generations. Taking a mortgage would by default mean taking a 30 year mortgage for a house where the couple would spend their entire life. However, the scenario has changed considerably in the past two decades.

Currently, most of the buyers go for fixed mortgage of 30 years or a fixed mortgage of 15 years. The shorter term mortgage is available at much lower interest rate because of the reduced risk on the lender.
Adjustable rate mortgage: An adjustable rate mortgage is a 30 year mortgage where the interest rate adjusts every year. The interest rate is pegged to the LIBOR index. This annual adjustment also has a cap attached to it.

Usually, annual increment cannot be more than 2% and also the maximum interest rate cannot go beyond 5-6 percentage points above the starting interest rate. The most important thing to note for this mortgage is that the payments can increase dramatically if the rates rise in the future. In ARM, the risk of interest hike is passed from lender to the buyer and hence these mortgages are available at substantially lower interest rates than a fixed rate mortgage.

Hybrid mortgage: This mortgage type includes the aspects of both fixed rate and adjustable rate mortgage. Typically the interest rate remains fixed for a certain period after which it is adjusted according to LIBOR. The terms and interest rates are specifically mentioned in every advertisement for such mortgages. A typical mortgage will look like:

Basic terms of a 5/1 2-2-6 ARM:

Figure: Different points given in an ARM mortgage advertisement
Terms Used

Fixed rate: First five years of the mortgage will be fixed.
Adjustment Period: After the first five years the rate will be adjusted every one year.

Margin: 1.75% (This is the lender’s margin that it charges over and above the Libor rate)

Starting Interest Rate: 2.75% (This is the interest rate charged at the start of the mortgage and for the first five years. Currently around 2.75%=1% Libor rate + 1.75% margin)

First adjustment: 2% (This is the maximum increment in interest possible in the sixth year)

Annual cap: 2% (This is the maximum increment in the interest rate which is possible in any subsequent year. If Libor increases by 4% in a given year, the lender will be able to increase the interest rate by only two percentage points)

Lifetime Cap: 6% (This is the maximum increment in the interest rate which is possible for a given mortgage. In this case it is 2.75%+6%=8.75%)

A yearly interest rate scenario for this mortgage will be:

1 1% 2.75% (No Change)
2 1.5% 2.75% (No Change)
3 2.5% 2.75% (No Change)
4 2% 2.75% (No Change)
5 3% 2.75% (No Change)
6 2.5% 4.25% (2.5%+1.75%)
7 3.5% 5.25% (3.5%+1.75%)
8 6.5% 7.25%(Maximum cap of 2% increase)
9 8% 8.75% (Lifetime cap on the interest rate, 2.75%+6% = 8.75%)
10 6% 7.75% (6%+1.75%)

It can be seen from the above table that the interest rate remains stable for the first five years. After the first five years, the interest is pegged to Libor and rises and falls according to it.

In the sixth year, it is 4.25% that is 2.5% of Libor rate and 1.75% of lender’s margin.

In the eighth year, the Libor rate increases 3% above the previous year. However, a maximum cap of 2% increase is allowed in the given terms of the mortgage. Hence, the mortgage increases to 5.25%+2%=7.25% in the eighth year instead of 6.5%+1.75%=8.25%. This is a major benefit for the buyers.

In the ninth year, the interest rate is 8.75% which is the maximum interest rate allowed in this mortgage. Ideally it would have been 8%+1.75%=9.75% but because of the lifetime cap it cannot exceed 8.75%.
In the final year, the interest rate is 7.75% or Libor +1.75% margin.

Given the current low rate regime it is much better to go with fixed rate mortgage than with an ARM. This would shield the buyer from any future interest hikes.

Interest only mortgage: In this mortgage the buyer pays only interest for the first five years. After five years, the buyer is required to pay both the principal and interest for the remaining 25 years. This mortgage is generally an ARM. It is suitable for households who would like to have minimum mortgage payment for the first few years. However, one should be ready for a huge increase once the interest only period ends. Many households also go for refinancing once this interest only period ends.

Payment options mortgage: This mortgage provides the buyer with additional options like paying an additional amount every month or paying only interest in a given month or even paying a given percentage of interest in a month. However, the terms of these mortgages should be carefully seen to make sure that they are suitable for the buyer. Additional options may lead a household into financial indiscipline causing bigger problems in the future.

Figure: Comparison of different mortgage rates in 2013-2014, Source: Freddie Mac

The mortgage rates are commonly in the following order:
30 years fixed mortgage, 15 year fixed mortgage, 5/1 ARM, 1/1 ARM
Fixed mortgage interest rates are higher as the lender is taking the entire risk of future interest rate movements.