About Loans

Learn about how loan structures work.

Mortgages

Amoritizing Loans versus Non-Amoritizing Loans

Amoritization payments

Non-amoritizing loans

Calculating a Loan Payment

Payment Types

Choosing an Interest Rate Structure

Interest Rate Structures

Adjustable Rate Mortgages

Calculating the Adjustments

ARM Rate-Move Limits

What is Negative Amoritization?

These days mortgages come in every form imaginable, and new varieties are being created all the time! Yet no matter how much they change, some basic features remain common to all types of mortgages. In fact, there are even some standard types of payment plans that you'll find repeated over and over, even in the newest mortgages being tested in the marketplace.

A mortgage is a special kind of loan. It uses real property-land and improvements such as a building or a house-as the collateral for the loan. That means the pledge of repayment to the lender is based on more than simply the borrower's creditworthiness. Because of the large amount of the loan, the property is also pledged as security for the loan. If the borrower defaults on a loan, the lender has the right to redeems the property.

Amoritizing Loans versus Non-Amoritizing Loans

Amortization is a word you're likely to hear when discussing mortgages. Although it's a mouthful to say, it really isn't such a complex concept. An amortizing loan is one with a specified number of equal payments that include both principal and interest. Amortizing loans are set up so that when the monthly payments are made according to the schedule, all of the interest and all of the borrowed principal will have been paid to the lender by the end of the loan term.

Lenders (and many financial calculators) use a formula to come up with the amortizing payment amount. We invite you to try our payment calculator to see how it works. You can calculate an amortizing payment for nearly any loan amount.

Seeing how the principal and interest are applied is also very useful to understanding amortization loans. By viewing our Amortization Schedule, you'll notice how, early in the loan the majority of the payment applies to interest, with a small amount applied to paying off the principal. As the loan matures and there is less principal remaining to be repaid, there is less interest owed to the lender, so more of the payment is applied to repaying the principal. By the end of the loan, only a small amount of interest is paid by the monthly payment, with most of it applying to the principal.

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Non-amortizing loans are generally known as interest-only loans. They allow a borrower to make monthly payments of just the interest part of a loan for a defined period of time-5 years for instance. A borrower can choose to make a larger payment to reduce principal, but if that never happens, then payments remain constant over the life of the loan. At some specified point, payments become fully amortizing over the remaining life of the loan.

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There are three basic ingredients that go into calculating a loan payment.

**Interest Rate** - The interest rate is simply what you pay to borrow your mortgage funds. Mortgage interest rates are quoted in annual percentages, while payments are almost always made monthly. The higher the interest rate, the higher your monthly payment will be. The lower the interest rate, the lower your monthly payment.

**Term** - This is the length of the life of the loan. The most common mortgage terms are 15 and 30 years, while 20- and 25-year terms are available. Also known as the Term to Maturity, because it represents the full term of the loan where all payments are made on schedule. You can shorten the time until a loan is fully paid by pre-paying all or part of your mortgage.

**Principal Balance** - The principal balance is the amount that you borrow. There are two types of principal balance. The beginning Principal Balance is also known as the Note Amount or the Loan Amount. The Outstanding or Unpaid Principal Balance is the amount remaining to be paid after you have already begun repaying the balance.

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Now that you have the basics of amoritization down, here's how the various mortgages and their payment types stack up against each other.

**Fully Amoritizing** - This type of loan has a specified number of payments that include both principal and interest. By making monthly payments according to the schedule, you pay off the principal balance with the very last payment of the loan term.

**Balloon** - This type of loan requires you to make periodic payments of principal and interest that do not fully amortize the loan. Payments are calculated using a 30- or 15-year term, but at the end of the 5th or 7th year (depending on the loan), the full unpaid principal balance becomes due in one lump sum, which is known as the Balloon Payment. The 5- or 7-year time frame is the Balloon term.

**Interest Only** - This type of loan payment requires you to pay only the interest due for each payment period. You have the opportunity to make additional payments at any time to reduce the principal balance. Because of this, the payment amount is re-calculated every month and is based on the current unpaid principal balance at the time of calculation.

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Choosing an Interest Rate Structure

One of the most important choices you will make in closing your mortgage is how you want your mortgage to be affected by changing interest rates. Your decision will help determine the loan program you select.

Your mortgage interest rate can be either Fixed or Adjustable, or it can be a hybrid of the two, that is, Adjustable following a Fixed period. You're going to want to carefully consider your options and how much payment change you're willing to tolerate over the life of your loan. The following information should make your choice a lot clearer.

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**Fixed Rate** - TThis type of loan has one interest rate that is set at the start of the loan and remains the same throughout the life of the loan. Because the interest rate does not change, the principal and interest (P&I) portion of your loan payment stays predictably the same. A fixed rate loan eliminates the uncertainty of what interest rates will do in the future. If interest rates decline during the life of the loan, you have the option to refinance. On the other hand, if mortgage rates climb, your fixed rate ensures that your P&I payments will not change.

**Adjustable Rate** - This type of loan starts with a low payment rate and automatically adjusts its interest rate every 1-year or 6 months. The interest rate can either go up or down, matching the behavior of interest rates in the economy over the same period.

Lenders are willing to initially offer a lower-than-fixed-rate start rate simply because they get the benefit of an interest income that is more responsive to the economy. The lower start rate is often attractive to borrowers who expect to live in a home for only a few years.

**Adjustable Rate, following a Fixed Period** - This group of loans was designed by lenders to provide more stability to a borrower at the start of a mortgage. Sometimes referred to as Hybrid ARMs, they combine the benefits of having a Fixed Rate mortgage during the initial period of the loan, after which the Adjustable Rate mortgages takes effect. As a rule of thumb, the longer the fixed period is at the start of the loan, the higher the starting rate will be.

Some of the standards you will see include:

• 3-Year Fixed followed by 1-Year Adjustments (for the remaining 27 years)

• 5-Year Fixed followed by 1-Year Adjustments (for the remaining 25 years)

• 7-Year Fixed followed by 1-Year Adjustments (for the remaining 23 years)

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The loan payment for the initial period of an Adjustable Rate Mortgage (ARM) is calculated using the Start Rate. The beginning payments are calculated as an amortizing loan, using the Start Rate as if it would remain the interest rate for the remainder of the loan. But remember, this is an ARM, so at the first Adjustment Date the loan payment is recalculated. The loan payment is re-amortized using the newly Adjusted Interest Rate, the Unpaid Principal Balance at the time of the adjustment, and the Remaining Term.

Let's look at an example, using a 1-Year Adjustable Mortgage. Here's what we need to calculate the initial Loan Payment.

For the First year

Start Rate (Example)

5.00%

Initial $ Amount of the Mortgage

$100,000.00

Full Term of the Loan

30 Years

Let's say the rate adjusts **up** at the beginning of Year 2:

For the Second year

Rate after Adjustment (Example)

5.50%

Unpaid Principal Balance end of Year 1

$98,524.66

Remaining Term of the Loan

29 Years

Next, we'll say the rate adjusts **down** at the beginning of Year 3:

For the Third year

Rate after Adjustment (Example)

5.25%

Unpaid Principal Balance end of Year 2

$97,103.45

Remaining Term of the Loan

28 Years

This is the process that continues throughout the life of the loan. Every year (because this is a 1-Year Adjustable Mortgage), a fully amortizing payment is recalculated based on the newly Adjusted Rate, the Remaining Term of the Loan, and the Unpaid Principal Balance at the time of the Adjustment. Because each adjusted payment is recalculated as a fully amortizing payment, the Principal Balance decreases every year until, with the final payment, the mortgage is fully paid off!

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So now you're probably wondering, just how do you calculate the new interest rate at each Adjustment?

Every Adjustable Rate Mortgage is tied to a specific leading financial index. The index is the variable that affects how the Adjustable Rate Mortgage's rate changes. It is the measuring stick that the lenders use to determine how high or low rates are in the economy when it's time for an Adjustable Rate Mortgage to adjust. Since an index will change as the economy's interest rates change, so too will the Adjustable Rate Mortgage's rate change at its adjustment date.

The following are some common indexes used as benchmarks for Adjustable Rate Mortgages:

• 1-Year US Treasury Index

• Federal Reserve 11th District Cost of Funds Index (COFI)

• London Inter-Bank Offering Rate (LIBOR) Index

• US major bank Prime Rate Index

When you apply for an Adjustable Rate Mortgage, the loan program clearly states which index it uses for recalculating the loan's interest rate at each adjustment. You will continue to use the same index throughout the life of the loan, and the index number will change based upon rates in the economy.

The index specified by your loan program is not the rate you will get at your next adjustment. There is another number, called the Margin, that is added to the index to arrive at your adjusted interest rate. But there are limits to the adjustments. Adjustments are regulated by caps.

Every ARM loan program has several limits to how much any single adjustment can change your interest rate. Let's take a look at all the factors that contribute to determine an ARM's adjusted interest rate.

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**Start Rate** - This is the beginning interest rate for your ARM loan. For a Fixed Period Adjustable Rate Mortgage, the Start Rate may be the interest rate for 3, 5, or 7 years before the first rate adjustment.

**Index** - This is the gauge used to measure the level of interest rates in the economy. When combined with the Margin, it is used to determine the new ARM interest rate at each adjustment. The loan program you select will specify the Index it uses. The Index itself is a neutral indicator of rates. It cannot be controlled by the lender.

**Margin** - This is simply a number provided in your loan program that is added to the Index to determine how much the interest rate will change at the loan adjustment. There is a set limit, or a "cap", to the amount an adjustment rate can change. A cap restricts the range of the adjustment to a reasonable change, eliminating any large spikes in change.

The Margin will not change over the life of the loan. It is the Index that is the variable that changes as the economy's interest rates fluctuate.

**First Rate Change Cap** - This is the maximum amount of change (either upward or downward) that limits how far the interest rate can change at your loan's first adjustment.

**Periodic Rate Change Cap** - This is the maximum amount of change (either upward or downward) that limits how far the interest rate can change for each adjustment following the first adjustment.

Sometimes the First Change Cap and Periodic Change Cap are the same. If a First Rate Change Cap is not stated, then all adjustments are considered Periodic Changes.

**Life Cap** - This affects how high the interest rate can adjust upward (and only upward) during the life of the loan. If you add the Start Rate to the Life Cap, the result is the highest the loan's interest rate can ever reach. The Life Cap limits the effect the Periodic Rate Change adjustments can have on your rate.

**Floor** - The Floor is the lowest interest rate the loan can reach during the life of the loan. Often, but not always, the Floor is the Margin. If the Index was to move to 0.000 (although very unlikely, it is theoretically possible), then the Index plus the Margin would equal the Margin!

You might be surprised to know that several caps can apply simultaneously during the ARM adjustment calculation. When that happens, the most restrictive cap is the one that takes effect. For example, if a periodic change cap causes the adjustment to increase the loan's rate to become higher than the life cap allows, then the life cap takes priority as the limiting factor for that adjustment.

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Let's look at an example of a First Adjustment on an ARM loan.

The First ARM Adjustment

Start Rate

5.00%

US Treasury Index (Example)

2.75%

Margin (Example)

2.50%

Proposed Adjusted Rate: Index + Margin (Example)

5.20%

An increase proposed from prior rate

Proposed Change = (Index + Margin) - Start Rate

.25%

First Change Cap (Example)

2.00%

Proposed change does not exceed First Change Cap

Life Cap (Example)

5.00%

Maximum Rate this loan can ever have = Start Rate (5.00%) + Life Cap (5.00%)

10.00%

Proposed change does not exceed Life Cap

Now let's look at what happens on the next Adjustment for the same ARM loan if the index goes up.

The Second ARM Adjustment

Start Rate

5.00%

Most Recent Adjustment Rate

US Treasury Index (Example)

4.00%

Margin

2.50%

Proposed Rate: Index + Margin

6.25%

An increase proposed from prior rate

Proposed Change = (Index + Margin) - Propose Rate

1.00%

Periodic Change Cap (Example)

2.00%

Proposed change exceeds Periodic Change Cap

Life Cap (Example)

5.00%

Maximum Rate this loan can ever have = Start Rate (5.00%) + Life Cap (5.00%)

10.00%

Proposed change does not exceed Life Cap

Let's extend this example for one more Adjustment, where the index jumps higher and the Periodic Cap restricts the interest rate adjustment on the loan.

The Third ARM Adjustment

Start Rate

5.00%

Most Recent Adjustment Rate

US Treasury Index (Example)

6.50%

Margin

2.50%

Proposed Rate: Index + Margin

9.00%

An increase proposed from prior rate

Change = (Index + Margin) - Start Rate

2.75%

Periodic Change Cap

2.00%

Proposed change exceeds Periodic Change Cap

Resulting Proposed Rate: Most Recent Adjustment Rate + Periodic Change Cap

8.25%

Life Cap (Example)

5.00%

Maximum Rate this loan can ever have = Start Rate (5.00%) + Life Cap (5.00%)

10.00%

Proposed change does not exceed Life Cap

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What is Negative Amoritization?

Some Adjustable Rate Mortgage programs have provisions for interest rate changes, but instead of interest rate caps, they offer payment caps. So the amount the payment can increase is limited, but the actual increase in interest rate is not limited. If ever the interest rates increase to the point that the capped monthly mortgage payment does not cover the interest due, any unpaid interest is still due and is added onto the loan balance, increasing the unpaid principal balance.

This situation is called Negative Amortization. Instead of the payment decreasing the loan balance toward being fully repaid-as in an amortizing loan�the loan size can actually increase. Most programs offering negative amortization also have a limit on how large the loan can grow before requiring the payment be re-calculated in order to amortize the loan for the remaining term.

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