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Conventional Fixed-Rate Mortgage Loans

Published by sam - 04/09/07 - 12:09:40 am

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There are several type of mortgage loans and understanding of each will help you determine the right one to choose from when financing your homes. The first in the series about loans we’re going to discuss is conventional fixed rate mortgage loans.

While the conventional fixed rate mortgage has to some extent been replaced by other types, it has by no means disappeared.

Although the fixed rate mortgage may appear to be more expensive than some of the alternatives, it is in many ways the most desirable kind of mortgage for most home buyers.

Interest rate and Terms 
As its name implies, this type of mortgage carries a fixed interest rate for its term, which may be as long as 30 years.   Generally each payment remains constant and includes interest and a portion of principal.  As the payments continue, the proportion applied to interest diminishes and the proportion applied to principal increases correspondingly.

This type of mortgage illustrates dramatically not only the total cost of mortgage interest but also the importance of seemingly small differences in interest rates over a long period of time.  If you borrowed $80,000 for one year at 10 percent with monthly repayments of interest and amortization of principal, your total interest cost would be $4,339.36.  If, however, your stretch the loan period to 30 years, your total interest cost would   rise to $172.741.60—more than twice the principal amount originally borrowed.  In a addition, a reduction of the rate to 9 percent would reduce your monthly payments by about $60 and save you almost $22,000 over the 30-year term.  Even a difference of one-quarter percent can save $5,000 over the life of the mortgage.

This is why it pays to shop around for the lowest available interest rate.  Some differences in interest rates, even if small, can be found in almost any community. So careful comparison shopping can pay off.

The rate you pay on the mortgage is essentially governed by the banks, but the term of your mortgage may to some extent be under your own control.  Invariably, the shorter the mortgage term, the less costly it will be, because you will be using the bank’s money for a shorter period of time.  As our example illustrates, the 30-year loan’s total interest cost is almost 40 times the one-year loan’s total interest cost.  Thus, a 15 or 20 year term, if you could afford the higher principal amortization, would save you a substantial amount.  An $80,000 mortgage at 12 percent would require a monthly payment of $823 on a 30-year basis and $960 on a 15 year basis.  But if you could afford the $137 differences, you would save a total of $123,480 in interest over the life of the mortgage.  (Of course, you might find another way to invest the $137 at a rate of return higher than 12 percent.)  In addition, many banks charge lower rates on shorter term mortgages.

As an alternative, you can reduce total interest costs if you agree to make more frequent mortgage payments—for example, $411.50every two weeks instead of $823 monthly.  If your cash flow permits it, this has the effect of shortening a 30-year 12 percent mortgage to 19 years, because you pay off more principal with each payment by making 26 biweekly payments each year instead of 12 monthly payments.

Points
Any rate comparison must take into account the points that banks generally add to mortgages.  A point is a free that must be prepaid, equal to 1 percent of the principal borrowed.  It represents the bank’s commission when it sells the mortgage to the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation, or provides the bank with additional profits if it decides to retain your mortgage.  Because the points represent the bank’s profit and have nothing to do with the salability of the mortgage, they may, in some situation, be negotiable.

Points have the effect of raising the actual cost of your loan, but the Truth-in-Lending Acts requires banks to include points in calculating the annual percentage rate of fixed rate mortgages.  Thus, the larger the number of points—which may range from zero to as many as four –the higher the annual percentage rate will be above the note rate or contract rate specified on the mortgage note.

Prepayment
Although interest rate, term, and points are the three most important considerations in your choice of a mortgage a prepayment clause is also a valuable feature.  Ideally, such a clause permits you, at any time during the term of the mortgage and as often as you choose, to make cash payments that are applied tit e principal.  By reducing the principal, you simultaneously shorten the term of the mortgage and reduce the portion of your monthly payment that is applied to interest, thus accelerating the amortization or gradual repayment of principal, and increasing your equity.  In some states, a prepayment clause is required by law in a mortgage.

The prepayment privilege is also very useful if there is a significant drop in interest rates during the life of the mortgage.  If, for example, your mortgage rate is 10.5 percent and interest rates fall to 8.5 percent, a prepayment clause allow you to borrow money at the lower rate and pay off the mortgage on which you are paying the higher rate.

A prepayment clause is desirable even if you don’t currently anticipate using it.  You are never obligated to use it, but, with the clause in place, an unexpected windfall, gift, or inheritance can help you shorten the term of your mortgage and reduce its overall cost. 

Some banks refuse to write a prepayment clause, others limit the number and scheduling of prepayments or assess a penalty charge for each prepayment.  But this may be negotiable.

There may be some disadvantage to paying off the mortgage as quickly as you can afford to.  If, for example, interest rates rise substantially to 15 percent and your mortgage rate is only 8 percent, your cash could be “earning” more if invested elsewhere than it would if used for prepayment.

Assumability
Although you may plan to spend 10 to 20 years in your home, the fact is that all sorts of circumstances—a job related move, for example, or a change in your family situation—may require you to sell in five years or less, possibly at short notice or in a slow real state market.  For this reason, another very useful feature of a mortgage is assumability—that is, the right of a buyer of your home to take over your mortgage—especially if your interest rate below prevailing rates.

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