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Fixed and Adjustable Rate Mortgage Basics for the Real Estate License Exam

Mortgage payment plans will be covered on the Real Estate License Exam. As economic times have changed, it has become apparent that a more flexible approach would better serve both the borrower’s and the lender’s needs. The particular terms and conditions of any mortgage loan are, of course, fixed by the lender within the parameters of applicable law, but some general descriptions apply to both types of payment plans.

Fixed-rate mortgages

A fixed rate of interest means that throughout the lifetime of the loan, the interest rate and the amount of the monthly mortgage payments do not change. What does change, however, in an amortized loan is the amount of principal and interest in each monthly payment.

On a mortgage loan, interest is charged on the unpaid balance of the principal. So as you pay off the principal each month, the amount of interest being charged actually declines. And because the payments remain the same, the amount of principal you pay off each month increases.

For illustration purposes only, say you borrowed $100,000 in a 30-year mortgage loan. The amount of the interest rate is moot for purposes of this example. Your monthly payment on the loan turns out to be $665 for 360 months (that’s 30 years x 12 months).

The first payment may consist of $585 in interest payment and $80 in principal payment. The amount of interest is so high at this point, because you’re being charged interest on the entire $100,000 loan. What that also means is that after you make that first payment, you still owe the bank $99,920 ($100,000 – $80 principal payment).

Because the principal has been slightly reduced, the amount of interest owed that second month is slightly less than the first month. Because the monthly payment remains the same, the amount of principal paid off is more than the first month. By the time the last payment rolls around, the situation essentially will be (almost) reversed, with $585 applied to payment of the principal and $80 applied toward the interest.

Adjustable-rate mortgages

An adjustable-rate mortgage (ARM) is a mortgage for which the interest rate is subject to change during the life of the loan. An ARM can be an amortized, straight, or partially amortized loan. Although the specific terms of an ARM are contained in the note, you need to be familiar with its general features.

The interest rate for the loan is tied to the index, a rate over which the lender has no control. A federal treasury bond rate or other federal rate of some sort frequently is used as the index. The borrower’s interest rate then is calculated by adding a predetermined rate called a margin to the index.

For example, if the index rate is 4 percent and the margin is 3 percent, the borrower’s rate is 7 percent. As the index changes, so does the borrower’s rate.

The borrower’s rate at any point in time for an ARM loan usually is subject to two limits that are called caps or ceilings, including:

  • The annual cap, which limits the amount that an ARM’s interest rate can be adjusted upward in any given year.

  • The lifetime cap or ceiling, which limits the total upward adjustment that the lender can make to the interest rate during the life of the loan, regardless of how high the index goes.

Another condition of the loan to be aware of is when the loan adjusts. Some loans adjust every year, others less often. Also some adjustable loans can be or are automatically converted to fixed rate loans after a specific period of time, for example five years.

A payment cap can be put in place in an ARM, meaning that even if the rate adjustments reach their maximum each year, if the resulting monthly payment increases to more than a specified amount, that payment cap keeps the payment within reasonable limits. In some cases, however, exercising the payment cap can lead to negative amortization, which means the loan balance increases by the amount owed but not paid.

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