Understanding Different Types of Mortgage
Congratulations, you’ve finally decided to purchase a home of your own! For most of us, the next step in this process is to select a mortgage. This can be a confusing task because there are many types of mortgage to choose from. Also, mortgages have varying characteristics, like the interest rate and loan length. So how can you begin to select the best mortgage? We’ve created the following guide with all the options available to assist you in making an informed decision.
When choosing a mortgage, there are a few exceedingly essential factors, like your interest rate. This is usually one of the first mortgage criteria to be settled.
The most popular choice is the fixed-rate mortgage. Fixed rate mortgages may come in 15-, 20-, or 30-year terms.
- With a 15-year mortgage, you get the lowest interest rate, but the highest monthly payments of the three. If you can manage the cost, this option allows you to pay off your home the fastest.
- A 20-year mortgage is a middle option. Your interest rate and monthly mortgage expense fall somewhere between the 15- and 30-year option.
- The 30-year mortgage grants the most affordable choice for payments. This option may be the least expensive monthly cost but may have the highest interest rate. Some homebuyers choose to leverage the long payback period in exchange for purchasing a more expensive place to live.
- Fixed-rate mortgages keep the same interest and monthly payments for the life of the loan.
- The constancy of a fixed-rate mortgage means that it’s easier to plan your budget.
- The interest rates on this type of mortgage are higher than on other types, like the adjustable-rate version.
- It is one of the slowest options for building equity in your home. In a fixed-rate mortgage, the bulk of your monthly payment may initially go towards paying off interest. With time, the interest proportion of your monthly payment will decrease. The equity in your home will increase as a result.
Choose a fixed-rate mortgage if you plan to stay in the home for 7-10 years. The monthly payments offer stability to your finances.
With an adjustable-rate mortgage (ARM), the interest rate will change during the term of the loan. How the interest is adjusted depends on which subset of ARM you selected.
- Variable-rate mortgages use an adjusting rate schedule for the duration of the mortgage. This schedule can be changed as frequently as twice a year, annually, or less. The good news is that these types of mortgages often cap the maximum interest that can be applied.
- Hybrid ARMs initially start with a fixed interest rate, followed by a period where the interest rate floats. Typical ratios are 3/1 and 5/1, where 3 and 5 are the number of years of fixed interest. The number 1 is the floating interest year. In a 3/1 mortgage, the first three years are at a fixed rate. During year 4, the interest rate will be different.
- Option ARMs are often used for large loans. Usually, a borrower applies for an option ARM for a loan larger than one for which he would normally qualify. This mortgage type gives borrowers one of four initial monthly payment options
- A fixed minimum payment;
- Interest-only payments;
- An amortizing payment over 15 years; or
- Another amortizing payment option over 30 years.
- ARMs tend to have a low fixed rate in the first few years. This can help save you some money upfront with interest payments.
- When the interest rates rise, the monthly mortgage payment can become unsustainable. Should this happen, it is easier for the borrower to default on their loan.
- If home values fall, it will be difficult to refinance your mortgage. You may also experience difficulty selling your home before the loan reset period occurs.
Choose an ARM if you plan to leave home before the floating interest rate occurs. Doing so may save you a lot of money in interest. To select an ARM responsibly, you must be at ease with a certain amount of risk before applying.
The biggest thing to remember about a conventional mortgage is that it is not insured by the federal government. This means that if the borrower defaults on the mortgage loan, the government does not protect the lender from loss.
Conventional mortgages can either be conforming or non-conforming.
- Conforming mortgages are less than, or equal to, the maximum allowable amount set by Fannie Mae or Freddie Mac. Both Fannie Mae and Freddie Mac are government-controlled agencies that trade mortgage-backed securities (MBS) between lenders and Wall Street investors. Conforming loans generally have lower interest rates than non-conforming ones.
- Non-conforming mortgages don’t fall within the limitations of Freddie Mac and Fannie Mae. A common type is a jumbo loan, which generally exceeds the loan limits of the government agencies. Jumbo loans allow borrowers to purchase more expensive homes. However, to qualify, you need both excellent credit and a sizeable down payment. You must also be able to manage interest rates that are higher than those for conforming loans.
- A conventional mortgage usually has low borrowing costs (even with slightly higher interest rates) compared to other mortgages.
- Mortgages backed by Freddie Mac or Fannie Mae may qualify for lower down payments. A borrower can pay as little as 3% of the purchase price.
- You need strong credit: a conventional mortgage requires a minimum FICO credit score of 620.
- Your debt-to-income ratio should be 45-50%.
- A down payment of less than 20% will result in a mortgage where you must get Private Mortgage Insurance (PMI).
The U.S. Government does not offer mortgages. However, it does play a critical role in helping increase the number of American homeowners. Three federal government agencies insure mortgage loans.
- The Federal Housing Administration (FHA loans) programs allow homeowners with less-than-perfect finances to qualify for homeownership. You don’t need excellent credit or a large down payment. Eligibility starts with just 3.5% of the purchase price as a down payment. The major disadvantage is a mortgage insurance premium (MIP, similar to PMI) will apply for the length of the loan. MIP payments can be shortened if you start with a 10% down payment. (It is still required for the first 11 years of the loan.) For every $100,000 borrowed, a MIP costs an extra $100 per month.
- The U.S. Department of Agriculture (USDA loan) offers loans through the Rural Housing Service (RHS). To qualify, you must live in a rural area and show financial need due to low or modest income. USDA/RHS borrowers can purchase a house with 0% down payment and below-market interest rates. Once you sign the contract, you can’t change the terms. As a borrower, you are not allowed to refinance your loan for a better interest rate. You are penalized with horrific prepayment penalties. If a USDA/RHS loan is the only way you qualify for a mortgage, you may want to take pause. It may be best to evaluate if you can afford a home right now.
- The U.S. Department of Veteran Affairs (VA loans) is a special program for active duty military, veterans, and their families. The loans are designed to be flexible with low interest. Those who qualify can avoid mortgage insurance and enjoy virtually zero down payment. Applicants should still be careful that they do not end up underwater on the loan. (This is where the market value of the home is less than what you owe on the principal). VA loan applicants should also be aware of the funding fee, which could range between 1.25-3.3%. Funding fees are dependent on your down payment, military status, and if you are a first-time borrower on a VA loan. For a $200,000 mortgage, a funding fee will be between $2,500 and $6,600.
The general advantages of a government-insured loan are that
- It provides much-appreciated assistance for borrowers who do not qualify for a conventional loan.
- You don’t need a large down payment to purchase a home.
As for disadvantages,
- You may be required to pay some sort of mortgage insurance premium, which is difficult to remove.
- Borrowing costs may be higher than traditional loans.
Consider getting a government-insured loan if the following two-part scenario applies to you. You are a borrower with little savings, and your poor credit will prevent you from getting a conventional loan.
With interest-only mortgages, borrowers initially pay only the interest on the loan. After a given period, they pay off the principal. This provides significant cost savings up front. (Some interest-only options require the principal to be paid as a lump sum.) The monthly “principal” payments are higher than a fixed-rate payment of the same loan amount. This is to ensure the loan is paid off on-time. As a result, interest-only mortgages tend to be more expensive in the long-term.
For borrowers who need to keep initial monthly payments low, this may be a reasonable option. If you do want an interest-only mortgage, you should be aware that the risk of default is high. You should also ensure your future cash flow will be large enough to manage the higher payments on the back-end.
This is a special type of interest-only mortgage; it’s usually short-term (approximately 10 years). Balloon mortgages consist of a very low payment for most of the term. At the end of the mortgage, the payment “balloons” due to the full balance becoming due. Because balloon mortgages depend on a lump-sum payment instead of a steady cash flow, they can be considered high-risk. They are more commonly used in the construction industry for short-term financing without collateral. Balloon loans are often unsecured and have higher interest rates compared to other types of mortgage.
If you’re looking to avoid Private Mortgage Insurance (PMI) but can’t afford a 20% down payment, consider a combination mortgage. It involves taking out two loans at 80% and 20% of the value of the home. The interest rate of the 80% loan is lower than the other loan, and fixed. The other loan may be a higher rate, a variable rate, or both.
Juggling the interest on two loans can be expensive. However, there may be a benefit to paying off the (more expensive) 20% loan first. You may lower your monthly costs and avoid the additional fee from PMI.
Reverse mortgages are marketed to seniors only. This type of mortgage allows them to tap into the equity in their home. They can use the equity for a line of credit, or the lump sum of a loan. Reverse mortgage loans have regular set monthly payments. Homeowners can also choose to not make these payments, and the lender may place a lien against the home. The lien would be for the amount of the loan and will be executed upon the borrower’s death.
Reverse mortgages are risky since you’re selling off the part of the house you own in exchange for cash. This puts your home and financial situation at risk through expensive debt. If you move, you will still be expected to repay the mortgage using the money from the loan. You may lose equity for long-term care expenses that many seniors may need.
Despite the risks, a reverse mortgage may be a suitable option for persons near retirement age if they have
- Considerable equity in the home; and
- No plans to move; and
- Need to supplement their income after retirement.
A home-equity loan uses the value in your home as security for the mortgage or revolving line of credit. It’s also known as a second mortgage. Home-equity loans and lines of credit generally have a higher interest rate than a first mortgage. Despite this, they may be worthwhile for funding home projects and other necessities, especially in times of low interest rates.
Now that you are familiar with the different types of mortgage available, you can begin to make plans. It’s recommended that you start by calculating the costs of each mortgage type for which you qualify. Then, you can start comparing them to see which type of mortgage would be most beneficial to you. Don’t compare the monthly payments alone. To fully understand the mortgage commitment, you must consider every cost and all the conditions related to the loan. A mortgage’s impact will have profound, long term effects on your financial situation. There is no one, universal “right” mortgage for everyone. Therefore, when choosing a mortgage, it is imperative that you select the right mortgage for YOU.