There are two typical types of mortgages in our industry today, the FHA mortgage, and the conventional mortgage. The main difference is that the FHA has a lower minimum downpayment than a conventional loan. A conventional loan has a typical minimum downpayment of 20%, but some mortgage companies go down to 10% or even 5%. But a FHA loan has a minimum downpayment of only 3.5%. In the case of putting less than 20% down, FHA has a Mortgage Insurance Premium (MIP) that is added to your closing costs, and to your monthly payment, while a conventional mortgage has a Private Mortgage Insurance (PMI) that is added to your monthly bill.
Adjustable Rate Mortgage
I know, Adjustable Rate Mortgage (ARM) has a bad rap in today's world. This is because there has been a lot of negative press about ARMs due to the foreclosure crisis. Many people were burned by having rates adjust, and many people didn't understand their product. But the ARMs that they are talking about usually are a balloon product, or an interest only product. Conversely there are some really good reasons to use an ARM product to purchase a home right now.
An ARM product is a mortgage product that does not have a fixed interest rate for the life of the loan. It can adjust. But that should not be immediately scary. Let's take a look at a couple variations and what they mean:
5/1 Arm - This product means that the first 5 years has a fixed interest rate, almost always lower than any 30-year fixed rate mortgage. It then can adjust every 1 year after that (the 1 part of the 5/1) with most likely a maximum cap on the interest rate, as well as a maximum it could adjust per year. This ARM product will have a lower interest rate than a 7/1 ARM or a 10/1 ARM.
The second part of this product is the length of the ammortization schedule. If you get a 5/1 ARM that is ammortized over a 30 year period, you are really getting a 30-year mortgage with a low interest rate for the first 5 years.
So an example of a 5/1 ARM might be like this:
5 year initial interest of 2%, 2% per year maximum increase, with a 5% lifetime cap, ammortized over 30 years. In some cases, keep in mind that the initial 5 year rate may be a teaser rate, and often will increase in the 6th year. In one case, the 2% rate for 5 years increases to at least 2.875 in year 6 and up to 4% maximum. But they guarantee that it will increase to at least 2.875%.
Year 1-5: 2% interest
Year 6: 2% + maximum increase 2% = 4%
Year7: 4% + maximum increase 2% = 6%
Year8: 6% + maximum increase 1% = 7%
In comparing a 5/1 ARM at 2% vs a Conventional Mortgage at 4%, the initial payment is lower. Here are the assumptions: $250,000 purchase price, 5% downpayment, principal of $237,500.
The 5/1 ARM at 2% yields a payment of $877.85 for P+I. The conventional at 4% yields a payment of $1133.86. This is a $256 saving PER MONTH. So in the first 5 years, you will save $15,300!
There are 2 positive scenarios from this example:
1. You can pay the extra $256 per month towards your principal. This extra payment will shorten the loan by 8 years and 6 months. That means you'll only have 21.5 years of mortgage payments. -- OR --
2. You can increase the purchase price of the house from $250,000 to $322,900 and have the same $1133.86 payment. This gives you much more buying power.
If you keep in mind that most people stay in their homes an average of 7 years, then the ARM can become an attractive alternative to the 30-year fixed mortgage. But also keep in mind that the interest rate can adjust, but most people think they will be making more money 5 years from now.
NOTE: I am not a mortgage professional. Please consult with a mortgage professional for more information.