Understanding the Different Types of Mortgages
There are many different types of mortgages out there. Generally, the shorter the term of the loan, the lower the interest rate is. If you know you may only be in your home for 5 years, you may not want to take out a 30 years mortgage. The following are some of the most common types of mortgages available by most reputable lenders:
Fixed Rate Mortgage
A fixed-rate mortgage offers an interest rate that will never change over the life of the loan. The primary benefit is that if interest rates increase during the term of your loan, your rates stay the same.
On the other hand, if interest rates drop during the term of your loan, your rates still stay the same (unless you refinance your home at the lower rate). This is the biggest difference between this loan and variable / adjustable loans (see next item).
The length (or "term") of a fixed-rate mortgage is usually 15 or 30 years. Each of these terms has its pluses and minuses:
30-year fixed rate - Is the most common type of mortgage. The 30-year term gives you maximum tax advantage by having the greatest interest deduction. It's also worth noting that the 30-year fixed-rate loan is often the easiest type of loan to qualify for. Assuming it is an amortizing loan, the payments and the interest rate are fixed for 30 years at which time, the balance of the loan will have been paid in full and the borrower owns the home free and clear.
15-year fixed rate - If you shorten your mortgage, you usually get a lower interest rate. but will increase the monthly amount you pay. Assuming it is an amortizing loan, the payments and the interest rate are fixed for 15 years, at which time, the balance of the loan will bee paid in full and the borrower owns the home free and clear. The monthly payments on a 15 year fixed will be significantly higher than the payments on a 15 year fixed, but the total interest costs over the term of the loan are significantly less.
Which loan is best for you depends on:
- The borrower's ability to make monthly payments based on his or her income
- The type of lifestyle you want to live
- Whether or not you feel you will be in the same home and the same mortgage for the entire term of the loan
- Your level of risk aversion
- Alternative vehicles to invest your money
Interest-Only
In an interest-only mortgage, each payment you make goes to pay just the interest portion of the loan. The loan balance remains the same and does not get paid down throughout the term of the loan. Usually, at the end of the loan term, the borrower will either have to pay the loan off in full (balloon payment) or refinance into a new loan. The benefit of an interest only loan is that the monthly payments are lower since you are not paying the balance of the loan down. Why would one be interested in an interest only loan when they are not paying down any of the loan amount?
Affordability - It may be the only way the borrower can afford the monthly costs, and they may be relying on the value of the property increasing (appreciation) over time.
Anticipate a Compensation Increase or a Year End Bonus - Some professions (such as doctors) begin their careers at one pay scale but expect a large increase within a few years. Other professions rely on year-end bonuses to make up a significant portion of their yearly compensation. People in situations like this will, often times, choose an interest-only loan. If you are anticipating a jump into a new pay scale shortly, you may choose interest only for now until you make the jump into the next pay category and then re-finance or buy a more expensive property. Additionally, most interest-only loans give the borrower the option of paying down principle at any time, at which time, the monthly payments will be re-calculated in order to determine a new monthly payment.
Invest money at higher rate - The borrower may feel they can invest the money that would have gone to principal in order to earn a higher return on the money. If this comes to fruition, at the end of the term, the borrower would have enough money to pay off the entire amount of the loan plus have additional money left over. The borrower would then have an asset that is free and clear, has probably appreciated in value over time, and still has money left over.
Adjustable Rate Mortgage (ARM)
The adjustable rate mortgage (or "ARM") offers a fixed initial interest rate with a fixed initial monthly payment. "Initial" is the key word here, because after some predetermined initial period, the loan is subject to changes in market conditions.
The initial interest rate you pay will probably be lower than a fixed-rate mortgage; but the uncertainty, of course, comes after the initial period. This type of loan is usually a good option for buyers who only plan to stay in a home for a short while.
In other words, if you turn around and sell the house before the initial fixed-rate period expires, you'll benefit from the lower rate and be out before the uncertainty sets in.
How often the interest rate adjusts with an ARM depends on the terms of the loan. Take the 5/1 ARM as an example. 5/1 means your interest rate would stay the same for the first five years and then adjust each year starting at the sixth year. A 3/3 ARM would offer an initial fixed rate for three years and would then adjust every three years starting at the fourth year.
These types of loans are better for borrowers who know they will not be in a home or the same mortgage for 15 or 20 years. The first number, the initial term, determines how long the loan is fixed for after which time, the loan turns into an amortizing loan to be paid in-full over the remaining number of years on a 30 year basis. ARMs, because of their shorter time horizon, will generally have lower interest rates than a longer-term loan, at least for the initial term. After the initial term, the rate may adjust each year up to a maximum rate that usually does not exceed 6% more than the initial rate. There also is usually an annual cap on the interest rate that does not usually exceed 2-2.5% per year.
Government Loans (FHA, VA, Mass Housing)
The most common types government backed loans that provide low down payment options to either first time home buyers, lower income buyers, or Veterans. In recent years, there have been fewer and fewer options available to buyers who would otherwise qualify for a mortgage but do not have at least a 10 or 20% down payment. Since there are fewer options available, these loans have become more and more popular.
FHA Loan - A loan insured by the Federal Housing Administration, open to all qualified homebuyers. There are limits to the size of FHA loans, but they are usually enough to cover most moderately priced homes. Provides an option for buyers to put as low as 3.5% down payment. There are some restrictions on the types of properties that qualify as well as minimum owner occupancy rates.
VA Loan - A long-term, low or no-down-payment loan guaranteed by the government that allow for Veterans to purchase a home and finance the entire purchase price.
Mass Housing - Provides an option for buyers to put as low as 3% down payment. There may be income restrictions and resale restrictions.
Please consult your loan officer for additional information on any of these low down payment options. Closing costs may also be covered for those who qualify.