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.

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.

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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.

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.

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

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

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.

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.

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

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

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!

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.

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.

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

Start Rate (Example)	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	0.25%
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
Resulting Interest Rate after Adjustment	5.25%

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

Start Rate	5.00%
Most Recent Adjustment Rate	5.25%
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) - Proposed Rate	1.00%
Periodic Change Cap (Example)	2.00%	Proposed change does not exceed 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
Resulting Interest Rate after Adjustment	6.25%

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.

Start Rate	5.00%
Most Recent Adjustment Rate	6.25%
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
Therefore, 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
Resulting Interest Rate after Adjustment	8.25%

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.