The great majority of American consumer debt is for mortgages, and with the average home selling price around four times the average household income, it’s understandable that the way to attain the American dream of home ownership is with a mortgage. Besides the standard 30 year fixed rate mortgage there are other home loan products available: such as the home equity loan and home equity line of credit, among others. Even for mortgages there are more options today (but fortunately for everyone there are fewer than about 10-12 years ago) than the basic 30 year fixed rate mortgage, and we’ll provide more information about several of these options here.
The primary loan that people use to purchase real estate is a mortgage. A mortgage is a standard installment loan, so it means that the same monthly payment is due each month, based on a standard amortization schedule that is determined in advance, and the payments are due on the first of each month. The most common term for a mortgage is 30 years, but other term lengths regularly available include 15 years, 20 years, and occasionally 40 years. The shorter the term the higher the monthly payment, but the less total interest will be paid over the course of the loan.
Fixed Rate vs. Adjustable Rate Mortgage (ARM)
Besides choosing the term that fits your situation best, you’ll usually have (at least) two choices in terms of choosing your interest rate, which will impact your monthly payment: either a fixed rate mortgage or an Adjustable Rate Mortgage, also known as an ARM. Fixed rate mortgages are simpler for the consumer, but leave more risk with the lender, so usually adjustable rate mortgages have lower initial rates, but also place more risk with the consumer.
The fixed rate mortgage is what it sounds like: your rate is fixed for the entire length of the mortgage whether that’s 15 years, 30 years, or more. Since your rate is fixed for the duration of the loan your monthly payment is also known for the entire loan as well, so in a 30 year mortgage your first payment will be the same amount as your 360th (and last) payment.
An Adjustable Rate Mortgage (ARM) is one where the interest rate can change at some point after the loan is funded. Usually it is 3, 5, or 7 years after the loan was funded, and when the new interest rate is determined it will be valid for 1 year. This is why you see the notation “5/1 ARM” – it means the initial interest rate is fixed for the first 5 years, and then the interest rate can change once each year after the fifth year, and that new interest rate will be used for the next 12 months / 1 year.
The reason a fixed rate mortgage has higher risk for the lender is because they need to consider current interest rates, but also forecast interest rates as much as 30 or 40 years into the future and ensure that it will still be a profitable rate for them at the end of the loan. Since it’s hard to know what may happen in 30 or 40 days, let alone 30 or 40 years, you can see why this can be a risky proposition. Conversely, in an adjustable rate mortgage the lender only needs to forecast for a fraction of the full loan term – again usually 3, 5, or 7 years, and can then adjust annually based on updated information as time goes on. Since the risk is reduced on the lender, it means it is going to the borrower, and the impact is because the interest rate, and in turn monthly payment, can increase after the initial fixed period has passed. However, keep in mind that there are various options you can use as the borrower to mitigate this and still take advantage of the lower initial rate that an ARM usually offers. We’ll show you how in an article about this topic that is coming soon.
Borrowing Against Home Equity
When you take out a mortgage to buy a home, you should have some equity in the home – that’s your down payment, and as time goes on your equity should be growing because of two things: one is that you are paying off principal of the mortgage each month with your monthly payment, and the other is that in normal times your home’s value is appreciating by about 2-3% per year.
Let’s assume that you purchased a home worth $200,000 and borrowed 80% of that ($160,000) in a 30 year mortgage with an interest rate of 4%. If your home value increases by 3% in a year, and you made all your mortgage payments on time, you will have increased the equity in your home by over $8,800. The 3% increase in the property value would be worth $6,000 and the principal payments on your mortgage in the first year would be $2,818. The second year would have an even bigger increase in dollar terms – over $9,100 – because you’ll pay more principal in your mortgage payment each month and the increase in property value is slightly higher because it’s based on the new value from the end of year 1.
Home Equity Loan
A Home Equity Loan is pretty much just a mini-mortgage: it’s an installment loan, with a specific term, usually a fixed interest rate, and therefore a fixed payment amount that is due each month. Like a mortgage, the interest paid can usually be claimed as a tax deduction*, and since the loan is secured by your property (but second in line to your mortgage lender), the rate offered is lower than unsecured loans, but likely not as low as your primary mortgage.
Home Equity Line of Credit (HELOC)
A Home Equity Line of Credit (HELOC) is more similar to a credit card account, but the credit limit is based on your home equity. It is a revolving line of credit – meaning you can pay back principal and then later access it again if you have a new need for borrowing. The interest rate changes more frequently, based on market interest rate changes, but you have the flexibility to pay a smaller minimum payment, sometimes as little as the newly accrued interest, at least in the early years of the loan.