10 Steps to Demystifying the Mortgage

Break down the home mortgage and determine the better one for you

By Broderick Perkins

Mortgage. It's a word and a concept that can strike terror in even the most stouthearted of potential homeowners. With its often baffling intricacies that determine how much more you do or don't pay every month, it's a justifiable anxiety.

Take heart, for we have the 10 essentials you need to soothe your mortgage-addled soul. In fact, the basics of mortgage loans are pretty easy to understand.

The Rate Remains the Same

When you choose a fixed-rate mortgage, you're assured your interest rate will remain the same for the life of the loan.

Loan Length. The life, or term, of a mortgage is 30 years by industry standards, but 15- and 20-year-term loans are also available.

Rate Reduction. Should you opt for a shorter-term loan, you can reduce your interest rate even further. For example, a 15-year rate is typically one-quarter to one-half percent lower than one for 30 years. The smaller rate and shorter term mean you'll pay less over the life of the loan than if you borrowed the same amount over a longer term.

Monthly Money. Of course, the shorter the loan term, the higher the monthly payments.

Higher Rates? Fixed-rate mortgages protect you from the risk of rising interest rates. But you could end up with a higher rate should interest rates fall.

ARMed and Ready

The second major mortgage category is the adjustable rate, or ARM. Initially, an ARM rate is lower than one that is fixed, about one-quarter to two points less, depending upon the economy.

Larger Loans. With its lower preliminary rate, ARMs can help you qualify for a larger loan or start off with smaller payments than with a higher fixed rate.

Rate Cap. Generally, ARMs have caps on how high it can adjust during each adjustment period and over the life of the loan. This protects you from drastic market changes, bit doesn't offer the stability of a fixed rate loan.

Income Increases. ARMs are a good choice for someone who knows their income will rise and at least keep pace with the loan rate's periodic adjustment cap.

Moving On? If you plan to move in a few years and aren't concerned about the possibility of a higher rate, an ARM could be a good choice.

Rate Changes. When the first adjustment occurs (usually between six and 12 months) and how often it adjusts depends upon the terms of the loan. After the first adjustment, subsequent modifications can occur every six months, once a year or longer. Should rates fall, so does your monthly payment.

Rate Configuration. To come up with an ARM rate, the lender adds a "margin," usually two to four percentage points, to the index. Its interest rate adjusts up or down, depending upon current economic trends and is based on a money market index. The one-year U.S. Treasury bill is commonly used because its yield is similar to the 30-year U.S. Treasury bill used to set rates on 30-year fixed mortgages.