- Like any loan, mortgages work on the basis of the borrower receiving a lump sum of money upfront and paying it back over time with interest. Many people discuss a mortgage's interest rate. However, a better measure of how much a mortgage loan actually costs is the APR, or annual percentage rate. The APR combines the interest rate and all of the costs of getting the mortgage into one number, expressed as a percentage rate. It levels the playing field between mortgages with different closing costs, allowing you to compare different loans.
- In addition to the interest rate, or APR, you should look at the type of mortgage that your lender is offering you. For most buyers, a fixed-rate mortgage is the most desirable in that its interest rate does not change over its life. However, you could also get an adjustable-rate mortgage, or ARM. ARMs have interest rates that can change over time. In exchange for the additional risk inherent in an ARM since the rate can go up, they typically offer lower rates than an equivalent fixed-rate mortgage when they are first made.
- ARMs can be based on a number of different indexes. What this means is that their effective rate is tied to some outside interest rate, called an index, and an additional charge, called a spread. For instance, if a loan's index is the prime rate and it has a 50 basis point spread, its rate would be 3.75 percent when the prime rate is 3.25 percent and 8.5 percent when the prime rate goes up to 8 percent. Although the prime rate is a popular index, other indices include the London Interbank Offered Rate (LIBOR), which is a rate based on how banks in London loan money to each other, and the 11th District Cost of Funds (COFI), which is set by a Federal Reserve bank. Commercial mortgages are frequently tied to the yields on Treasury bonds, with 10-year commercial mortgages tied to the 10-year Treasury, seven-year mortgages tied to the seven-year Treasury, and the like.
- Another determining factor in a mortgage payment is its amortization, or its life. Typical residential mortgages are amortized over 30 years, meaning that they will be paid off after 30 years. You can also opt for a shorter-term mortgage, such as a 15-year term, which will have higher payments but will pay off more quickly. On the other extreme is a non-amortizing, interest-only mortgage where you make interest payments but never pay down the value of the loan. These "IO" loans require periodic refinancing.
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