Mortgage Loans

Home mortgages in today’s market come in many different types, but they generally fall into one of two broad categories as follows:

Fixed rate mortgages (FRMs); or
Adjustable rate mortgages (ARMs).

The meaning of these home mortgages is explained below, including popular options within each type such as interest-only mortgages and flexible payment mortgages.

Fixed Rate Mortgages

Fixed rate mortgages (FRMs) specify the interest rate which is to apply for the full term of the loan. This means that the mortgage lender is not able to increase the rate of interest which applies to the mortgage at any time. But it also means that the borrower is not able to reduce the interest rate for so long as any balance on the mortgage remains outstanding. Unless the mortgage is a special type of FRM (such as one which specifies low initial payments followed by increasing payment amounts), then not only is the interest rate fixed for the entire loan term, but the payments are fixed also.

A consequence of fixed rate mortgages is that the mortgage is fully and exactly repaid at the point at which the final payment occurs at the end of the designated loan term.

The loan term for fixed rate mortgages can vary widely. The most common term is 30 years, but 15-year FRMs are prevalent also. However, borrowers can negotiate alternative periods from as short as 10 years or less to periods which extend to 40 years or more.

An increasingly popular version of FRMs in recent years is the interest-only mortgage. This is a mortgage which, for a specified initial period, has payments which only cover the interest which accrues on the loan amount. No amount of principal is included in the mortgage payment, which means that payments are initially lower but the principal outstanding does not reduce for the interest-only period. After the specified interest-only period the mortgage reverts to a normal FRM, so payments increase due to the addition of repayments of principal.

Home mortgages which have a fixed interest rate have the advantage of providing certainty to borrowers regarding future payment amounts, right to the end of the mortgage term.

Adjustable Rate Mortgages

Adjustable rate mortgages (ARMs) are quite different to fixed rate mortgages. With an adjustable rate mortgage, the rate of interest can be varied by the lender (within specified constraints) both after an initial period and then at every interest rate review date. Adjustable rate mortgages invariably specify a rate of interest for an initial period which is lower than the current assessed market rate of the mortgage to that particular borrower, but subsequent adjustments tend to compensate the lender by applying rates which are higher than the assessed initial rate. In this way, adjustable rate mortgages are designed to attract borrowers to a particular lender and to a particular mortgage type.

The initial fixed-rate period for an adjustable rate mortgage varies widely. It can range from as little as one month to more than five years. Subsequent interest rate reviews commonly occur every year thereafter, although some mortgages specify much longer review periods, such as five years.

Interest rate changes for adjustable rate mortgages occur according to a specified formula, in which the adjusted rate is calculated as a particular index rate plus a pre-determined loan margin. Loan margins are negotiable, but are commonly set in the range of 2.0% to 3.0% per annum. For example, if the value of the particular index is 3.5% per annum on the rate review date, and the margin is 2.5% per annum, then the adjusted interest rate will be 6.0% (3.5% + 2.5%).

There are many, many variables which can apply to adjustable rate mortgages, all of which can confuse prospective borrowers and make comparisons very difficult without expert assistance. For example, some adjustable rate mortgage contracts allow ‘negative amortization’ such that regular payments are less than the interest which accrues on the mortgage. In these cases the interest deficit is added to the principal outstanding, so that the loan amount actually increases over time.

Seek Advice

Our recommendation is that you seek independent, professional advice. It is most important that the advice is sought from someone:

who you trust;
who is, on enquiry by you, competent to provide that advice; and
who has no conflict of interest in providing that advice to you.

Clearly this means, for example, that the advice of loan officers of mortgage lenders must not be relied upon by you in making contractual decisions on any mortgage, as their task is to arrange and complete home mortgage contracts. Their first duty, necessarily, lies with the mortgage lender.

Be particularly careful with adjustable rate mortgages, as this type of home mortgage can be quite complex.