To quote a mortgage broker: “There is a different loan for a different need.” In
other words, the type of mortgage you get depends on your individual situation.
A good lender will get a sense of your needs from your credit report, your assets,
and your employment history. He can then recommend some options for you. Here’s
a rundown on the most common loan types.
Fixed-Rate Mortgage
Description: Interest is fixed for an amount of time; e.g., 10,
15, 20, 30, or even 40 or 50 years, at which point the
amortized principal is paid in full.
Pros: Security. You know what your payments will be. You can
Cons: If rates go down, you’ll still be paying the initial rate
unless you refinance.
Watch out: This is a long-term prospect; if you are keeping your
home for 15 or even 30 years, it’s a conservative way to go. But you can end up
paying more short-term than if you had an ARM.
Adjustable-Rate Mortgages (ARMs)
Description: The interest rate fluctuates with an indexed rate
plus a set margin; adjustment intervals are predetermined. Minimum and maximum rate
caps limit the size of the adjustment.
Pros: Initial rates are lower than fixed. Popular with those who
aren’t expecting to stay in a home for long, or in a hot market where houses appreciate
quickly, or for those expecting to refinance. You can qualify for a higher loan
amount with an ARM (due to the lower initial interest rate).
Cons: Always assume that the rates will increase after the adjustment
period on an ARM. You are betting that you’ll save enough initially to offset the
future rate increase.
Watch out: Check out the frequency of the adjustments. The more
often, the lower the starting rate, but the more uncertainty. The less often, the
higher the rate, but a little more security. Check the payments at the upper limit
of your cap (your rate can increase by as much as 6 percent!); you can get burned
if you can’t afford the highest possible rate. And planning that a
refinance will bail you out is risky; what if you can’t afford (or can’t
qualify for) that when the time comes?
1-yr. Treasury ARM
Description: The rate is fixed for one year, then becomes adjustable
every year. The new rate is determined by the
treasury average index plus the loan margin (usually 2.25-2.5%). 30-yr.
term.
Pros: Lower rates than a fixed mortgage. When rates go down, you
benefit.
Cons: Watch the margin; the margin is added to the index to come
up with the new rate after the adjustment period. When rates are going up, you could
end up paying more interest than with a fixed.
Watch out: If you are a gambler and think the rates won’t increase,
this might work for you. But if you are into it for the long or even intermediate
run, fluctuating interest rates can mean higher payments over time.
Intermediate ARM
Description: With an intermediate or hybrid ARM, the rate is fixed
for a period of time, then adjusts on a predetermined schedule. This is shown by
the number of years the loan is fixed, and the adjustment interval (e.g., 3/1 ARM
is 3-year fixed, and 1 adjustable annually). The new rate is determined by an economic
index (usually treasury or treasury average index) plus the loan margin (usually
2.25-2.5%). 30-yr. term.
Pros: Lower rates than a fixed mortgage. When interest rates rise,
you see more ARMs because they are easier to qualify for.
Cons: When rates are going up, you could end up paying more interest
than a fixed-rate mortgage after the initial period.
Watch out: If you aren’t planning to keep your house for long this
might work for you because you will receive lower rates initially. Be sure to check
the rate caps so you know exactly how high your payments can go. Fluctuating interest
rates can mean higher payments over time.
Flexible payment option ARM
Description: The borrower chooses from an assortment of payment
methods every month. There is a “change cap” limiting how much payments can vary
in a year.
Pros: Frees up cash when you need it. Good for buyers with variable
incomes (e.g., salespeople who work on commission).
Cons: Some options won’t cover your interest. With lower payments,
your balance increases each month, and eventually your payments will increase substantially.
This could lead to negative amortization.
Watch out: Eventually you will be required to pay down the principal
and your payments will increase drastically. If you can’t make them, you lose the
house. Most experts say, “Don’t do it.”
Interest-only ARM
Description: For a period of time, you pay only interest, and do
not pay down the principal.
Pros: If you don’t plan to stay in a home long, you can buy something
you ordinarily couldn’t afford. If you are in a hot market, or a hot neighborhood,
you’ll have low payments while your house appreciates in value. You can always pay
more on the principal while enjoying the low payments.
Cons: The day will come when you need to pay down the principal.
If your home value has fallen, or your income decreased, you could have trouble
making the new payments.
Watch out: If you can’t pay interest and principal at the same
time, chances are you can’t afford the house. You can only put off the inevitable
for so long: The principal has to be paid down. If you can’t make payments, you
could lose the house. If you plan to sell your house and can’t sell it for what
you owe, you are in trouble.
Convertible ARM
Description: An ARM that can be converted to fixed rate after a
period of time.
Pros: Saves on refinance costs, assuming you would have been switching
anyway.
Cons: You will have a higher rate for the fixed with a convertible
loan. You can’t look around for a better deal, which you can with a refi.
Watch out: Saving the cost of the loan and the hassle of shopping
loans are a plus, but you might be crying if the refinance rates are lower than
your new fixed. Experts say, “Just refinance.”
Jumbo loans
Description: Above Freddie Mac
and Fannie Mae conforming guidelines, therefore the big secondary lenders
will not secure jumbo loans. 2006 maximum amount for a conforming loan: $417,000.
Pros: When the market is out of sight, the jumbo loans make a purchase
possible.
Cons: Higher down payments, and higher interest rates.
Watch out: If you can afford the higher payments, then go for it.
But make sure you can afford them.
Assumable mortgage
Description: An adjustable-rate loan, the balance of which can
be assumed by a home buyer.
Pros: Sellers can offer a low interest rate to entice buyers.
Cons: This is almost never a fixed rate mortgage, so the savings
might not be all that great.
Watch out: These are rare today. If the buyer who assumes the loan
defaults, the bank will go after the original borrower.
Balloon conforming mortgage
Description: Interest rate is fixed for a period of time, but the
principal is not completely amortized. For the remainder of the term, it adjusts
to a new fixed rate determined by the Fannie Mae net yield index plus the margin.
30-yr. term
Pros: Lower monthly payments initially. If your career (and salary)
has a good future, or you are in a hot market and plan to sell before the balloon
comes due, you can save moolah.
Cons: Who knows what that new rate will be? There’s a looming debt
in your future.
Watch out: You can refinance when the balloon comes due, but you
are gambling that you can afford the refi loan.
Balloon mortgage
Description: The rate is fixed for a period of time, but the principal
is not completely amortized during the period. The entire balance of the principal
is due as a balloon payment at the end of that period.
Pros: Lower monthly payments, with the idea you can always refi
or sell before the balloon.
Cons: A big elephant waiting in the wings.
Watch out: It’s easy to procrastinate, or your life changes, and
then your balloon pops. Refi costs might offset any savings you made.
Veteran Administration Loans
Description: A zero-down loan offered to veterans only, the VA
guarantees the loan for lenders.
Pros: Nothing down, and no mortgage insurance. The loan is assumable.
Cons: It’s possible the rate is more than conventional loans or
FHA loans.
Watch out: Shop around first. Lenders are getting paid a 2 percent
service fee by the government, so your points should reflect a discount when compared
to similar rate loans.
Federal Housing Administration Loans (FHA)
Description: Government-subsidized loan with low down payment (i.e.,
as little as 1-3%) and closing fees included; the government guarantees the loan.
Pros: Low rates for those who can’t come up with the down payment
or have less-than-perfect credit; great for first-time homebuyers. The loan is assumable.
Cons: If you can afford 5 percent down, you might find better rates
with conventional loans
Watch out: Shop around first. Lenders are getting paid a 2 percent
service fee by the government, so your points should reflect a discount when compared
to similar rate loans.
Reverse Mortgage
Description: A loan to elderly homeowners who need to borrow against
the equity of a home while still living in it. The debt does not need to be repaid
until the house changes hands. Interest is commonly one-year treasury rate, plus
a margin and a cap on a rate change.
Pros: Allows people 62 or older to stay in their homes as they
age; no repayments.
Cons: You must maintain your house, pay property tax, and insurance.
And you cannot take out a second mortgage or rent your home, or use it for business.
Watch out: The loans are complex, so make sure you understand what
you are getting. AARP has good consumer-oriented
explanations for seniors. Choose a lender who is member of the National Reverse
Mortgage Lenders Association.
Related Articles
- How to Choose: ARM or Fixed-rate
Mortgages - Getting a Home Equity Loan
- Learning About Refinance Home Loans
- Finding Edge-Case Mortgages
- What is an Index?
- Is a Reverse Mortgage for
You? - Mortgage Types Fearbusters
- Mortgage Type Tips
© Zillow, Inc. 2009. Originally posted – Types of Mortgages and Home Loans
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