In: Root » Legal and finance » Loans and mortgages
Fixed-rate mortgages are easy to explain. You get an interest rate for a mortgage and it’s fixed. It doesn’t change. Ever. Easy enough, right? The only thing you and the clients need to decide about a fixed rate is what the rate will be and over what period to amortize the loan. Amortization is the fixed period during which the borrower repays the loan. If the amortization period is 20 years, then the loan will be paid off in exactly 20 years. The monthly payments remain the same, fixed, throughout the life of the mortgage. Amortization periods can be mostly whatever the lender offers, but if a lender wants to sell the loan to Fannie Mae or Freddie Mac, then the loan must conform to Fannie Mae or Freddie Mac standards and amortize over 10, 15, 20, 25, 30, or sometimes 40 years. The interest rates and how much interest the borrowers will pay throughout the lives of these loans differ. The longer the loan term, the lower the payment simply because the payback period is longer. For example, on a $200,000 15-year fixed-rate mortgage, you might find a 6.00% rate. That payments calculates to about $1,688 per month. Over 15 years, the clients will have paid the lender a total of $303,788. That means the lender made $103,788 in interest charges. That same amount on a 30-year loan at 5.50% works out to a $1,136 monthly amount. Over 30 years that adds up to $408,808. The lender makes $208,808. Yes, the monthly payments are lower with a 30-year loan, but over the long haul that’s twice the amount of interest. The time over which a loan amortizes affects how much of each monthly payment applies to interest or principal. In fixed-rate mortgages, most of the initial payments go to interest and very little goes toward repaying the principal. But when the loan term is shortened, say from 30 to 15 years, the note is paid down quicker. Using the same example as above, after five years the principal balance on the 30-year loan is $184,921. The original mortgage is paid down only by $15,079. With the 15-year example, the loan balance is $152,018, a difference of $47,982 after just five years. So there’s a tradeoff with amortization. Lower payments also mean slower loan pay down. Fixed loans can also have another feature called a balloon. A balloon is a loan that comes due in full after a predetermined period has elapsed. Many conventional balloons come due after five years and are called ‘‘thirty-due-in-five’’ and written as ‘‘30/5.’’ Again using the above example, after five years the 30-year loan’s outstanding balance of $184,921 becomes due—all of it. The loan has to be refinanced or the property otherwise sold off to avoid the balloon payment. Who would want a balloon payment? Lenders offer balloons because they can offer a reduced interest rate. And they’re particularly attractive if borrowers don’t think they’ll have the mortgage that long anyway. A 30/5 interest rate might be 5.25% instead of 5.55%. There’s another version of a fixed-rate, sometimes called a two-step or a 5/25. This loan offers a reduced rate for the first five years, then makes a one-time adjustment to another rate for the remaining 25 years. There are also two-step loans called 7/23s that work similarly.
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