You can select one of two basic options when applying for a mortgage:
1. Adjustable Rate Mortgage (ARM)
2. Fixed Rate Mortgage (FRM)
A mortgage with a fixed interest rate is called, oddly enough, a fixed rate mortgage. The interest rate is applied to the principal, and stays at the same rate throughout the life of the loan, which is also fixed, usually at 15 or 30 years.
However, Adjustable rate mortgages or "ARM's", as indicated by the name, has payments (principal plus interest) that adjust or change with direct correlation to changes in the existing prime rate, U.S. Treasury bills, certificates of deposits (CD's), the Cost of Funds Index (COFI)during the life of the loan. However, there are limits, as specified in the terms of the loan, as to how much that payment can change during the life of the loan. Many have a cap of 2-3 percentage points change during a year with a lifetime cap of 6 to 8 percent.
The continuous changes of the financial markets and prime rates affect the lending industry as well. These changes may affect your ability to repay at some point during the life of the loan. It is very important to consider this possibility before getting a loan. Before approaching the mortgage company, you should create three financial scenarios that may occur during the life of the loan. This litmus test will help you decide what amount is reasonable for you to borrow. It's a tedious task, but one that is well worth it. Though winning the lottery would affect your ability to repay, it's usually not listed in this exercise.
There are three scenarios. The average scenario consists of expected monthly income as well as the average of the expected monthly expenses. The less than average scenario consists of 20% lower than the aforementioned expected monthly income as well as 10% higher estimated average monthly expenses, on top of cost of living increasing of 4% each year. The worst case scenario consists of six months worth of unemployment without any income as well as cost of living adjustments of 5% on top of anticipated expenses each year.
Examining a variety of scenarios prior to searching for a new home will equip the potential buyer to seek an appropriately priced home. Equally important is - prior to finding a lender - understanding the varying risks that presented by an ARM, including but not limited to increases in monthly payments and "surprise" financial setbacks during loan's life. It is wise to pay bills in a timely fashion, which in turn establishes a solid credit history. This will encourage a lender to consider you a potentially great customer, and not a potentially great risk.
