Mortgages: fixed, ARM, points, PMI

In short

A neighbor of mine once told me he picked his mortgage the way he picked a pair of boots, by looking at the price tag and nothing else. He learned the hard way that the tag is only the start of the story. If you are shopping for a home loan, you will do better by comparing a few things side by side. Ask each lender for the interest rate, the annual percentage rate, the fees, and the monthly payment in writing. Find out whether the rate stays fixed or can change after a set period. Ask what the lender charges for points, and work out how long you would stay in the home before they pay off. Learn whether your down payment is large enough to skip private mortgage insurance. Take your time. A few hours of careful reading can save you thousands of dollars.

The whole of it

What it is

I once watched a young couple sign their loan papers with their hands shaking, and I thought, nobody ever explained this to them plainly. So let me try, the way I would on a porch with a glass of tea. A mortgage is a loan used to buy a home, and the home itself backs the loan. The borrower has to repay the money with interest over a set number of years, often thirty or fifteen. If the borrower stops paying, the lender can take the home through a process called foreclosure.

You have probably heard four words tossed around at the kitchen table: fixed, ARM, points, and PMI. A fixed rate mortgage keeps the same interest rate for the whole life of the loan, so the principal and interest part of the payment never moves. An ARM, short for adjustable rate mortgage, starts with one rate and then changes on a schedule written into the contract. Points are fees paid up front to the lender, and one point equals 1 percent of the loan amount. PMI, short for private mortgage insurance, is a monthly charge that protects the lender, not the borrower, when the down payment is small. None of these words is hard once someone says it slowly.

How it works

A friend of mine, a retired schoolteacher, liked to say that a mortgage is mostly interest at the start and mostly house at the end. She was right. In the early years, each payment goes mostly toward interest. Over time, more of it goes toward the amount borrowed, which is called principal.

With a fixed rate, the rate is locked. Tomorrow's headlines do not change it. That steadiness is what many families want, because the budget stays the same for decades. Taxes and insurance paid through the lender can still rise, so the full monthly bill can move even when the rate does not.

An ARM works another way. The loan has a starting period, say five or seven years, where the rate holds still. After that, the rate resets at set intervals. The contract names an index the rate follows, a margin the lender adds on top, and caps that limit how far the rate can climb at each reset and over the life of the loan. The lender must disclose these terms, and the borrower should read them closely. A low starting rate can feel like a gift. Still, the borrower has to be ready for the day it changes.

Points work like prepaying interest. The borrower pays money at closing and, in return, gets a lower rate. Whether that is worth it depends on how long the borrower keeps the loan. The break even point is the up front cost divided by the monthly savings.

If you are putting down a small share of the price on a conventional loan, PMI may come along with it, since the lender sees a smaller down payment as more risk. The Homeowners Protection Act, a federal law, sets rules for when the lender must cancel PMI. The Consumer Financial Protection Bureau explains those rules on its website. Loans backed by the FHA have their own insurance charge, and the rules differ, so a borrower should ask which one applies.

The numbers, and where to find yours

You have probably noticed that every lender quotes a different rate on the same day. That is normal. The rate you are offered depends on your credit score, your down payment, the loan size, and the loan type.

The official limit on how large a loan can be and still count as a conforming loan is set each year by the Federal Housing Finance Agency, and it is the current figure, which the official source publishes each year. Loans above it are called jumbo loans and often carry different terms. The point at which PMI must be cancelled by law is set by the Homeowners Protection Act, and the threshold is the current figure, which the official source publishes each year of the home's original value. The share of the mortgage interest you can deduct on a tax return, if you itemize, depends on the rules in force that year, and the current figure is the current figure, which the official source publishes each year.

To find your own numbers, start with the Loan Estimate. Federal rules require a lender to send this three page form within three business days of a complete application. It lists the rate, the monthly payment, the closing costs, and the points in a standard layout, so two lenders can be compared line by line. Your credit reports are free to view through AnnualCreditReport.com. The Consumer Financial Protection Bureau also posts plain language guides and a tool for finding current rate ranges.

A worked example

Let me tell you about a woman named Marisol. She bought a small house for $300,000 and put down $30,000, which is 10 percent. That left a loan of $270,000. Because her down payment was under 20 percent, her lender required PMI.

Her lender offered a thirty year fixed rate of 6.5 percent. The monthly principal and interest on $270,000 at that rate comes to about $1,707. Her lender also offered to lower the rate to 6.25 percent if she paid one point. One point is 1 percent of $270,000, which is $2,700.

At 6.25 percent, the monthly principal and interest drops to about $1,662. The savings is $1,707 minus $1,662, which is $45 a month. To find the break even point, divide the cost by the monthly savings. That is $2,700 divided by $45, which is 60 months, or five years.

So the question for Marisol was simple. Would she keep this loan for more than five years? If she planned to sell in three, the points would cost her more than they saved. If she planned to stay fifteen years, the points would save her about $45 times 180 months, which is $8,100, against the $2,700 she paid. She thought about her job, her neighbors, and her plans. Then she made her choice with her eyes open.

Her PMI added to the bill too. Say the lender charged $150 a month. Her total for principal, interest, and PMI would be about $1,812 at the lower rate, before taxes and insurance. As she paid down the loan and the home's value held, she could ask the lender to cancel PMI once she reached the threshold in the law.

Where it goes wrong

A man I knew took an ARM because the first payment was low, and he never read the part about the cap. Five years later the payment jumped, and he was not ready. That story repeats itself more than it should.

The common trouble spots are easy to name. A borrower can focus on the monthly payment and forget the total cost over the life of the loan. A borrower can buy points and then move or refinance before the break even date. A borrower can assume PMI goes away on its own and keep paying for years when a simple request would have ended it. A borrower can compare rates but not fees, and the APR, which folds many costs into one yearly figure, helps with that.

Another snag is the rate lock. A lender can promise a rate, but the promise may expire before closing. The borrower should ask how long the lock lasts and what it costs to extend. Stretching a loan to thirty years lowers the payment but raises the total interest paid. Nothing is free.

Questions to answer before you leave this page

Have you written down how long you honestly expect to live in this home, and does that match the loan you are leaning toward? Do you know whether your rate is fixed or can change, and if it can change, do you know the cap and the date of the first reset? Have you asked each lender for a Loan Estimate and laid them side by side? Can you divide the cost of any points by the monthly savings and say the break even in months? Do you know whether your down payment triggers PMI, what it costs each month, and when the law lets you end it? Could your budget handle the highest payment the contract allows, and not just the first one? And have you asked someone you trust, a housing counselor perhaps, to look over the papers with you before you sign?