Buying a home is a huge financial decision. Among the myriad decisions you need to make is deciding what type of mortgage loan to take out to finance your new home.
Mortgage loans can be categorized into many different types based on interest rate, the amount borrowed, term of the loan and its amortization, payment amount and frequency, as well as if there is any government programs involved. There are many federal and state and local government housing programs. The commonly known government guaranteed mortgage loans are the FHA loans and VA loans. But the loans most homebuyers get are conventional mortgage loans without direct government assistance. And that’s where various types of mortgage loans have been devised and marketed to borrowers to suit their individual financial needs.
Fixed-Rate Mortgage Loan
Despite many other types of newer mortgage loans, fixed-rate mortgage remains most popular. Nearly 70 percent of home mortgage loans are fixed rate loans. A traditional fixed-rate mortgage offers the borrower the certainty and stability of a constant interest rate and mortgage payment. While many loan terms are available, from 10 years to 40 years or even 50 years, getting a 30-year or 15-year fixed-rate mortgage is more common. Monthly payment is much lower when the total amount is spread over a longer period with a 30-year loan, though interest rate is higher than that for a 15-year loan. With a lower interest rate and higher monthly payments, a 15-year mortgage can save half of the interest over the term of the loan.
Variable Rate Mortgage Loan
A variable rate mortgage is also known as adjustable rate mortgage or ARM. The interest rate on such a loan is tied to an index, commonly Treasury Bill or Cost of Funds Index, and changes with prevailing market rates. They can be adjusted every year, every 6 months, or any other term as specified in the loan. Therefore, payments change through the life of the loan. While borrowers can benefit from a lower rate, too much upward rate adjustment may make a variable rate loan suddenly unaffordable. As such, many ARMs have rate caps, both a periodic rate cap and a lifetime rate cap that limit the amount of interest rate increase each adjustment period and over the term of the loan respectively. A borrower needs to weigh the value of lower initial interest versus the ability to pay higher mortgage payments later on if rates adjust upward.
Hybrid Mortgage Loan
Instead of offering either a fixed or a variable mortgage, loans that combine both features have gained popularity. Two kinds of such loans best illustrate the advantages of having both elements in one product: fixed-period ARMs and convertible ARMs. With a fixed-period ARM, the interest rate is fixed for the first number of years, commonly 3, 7, or 10, providing certainty for that period and the rate is normally lower than what’s for a traditional fixed rate because the lender has a chance to adjust it higher in the later adjustable period. But there is also a first time adjustment cap to limit the interest rate the borrower pays the first time the rate is adjusted. With a convertible ARM, the borrower is given the option to convert the loan to fixed during a designated period of time, for example, the first 5 years, if the borrower sees that the rate is on the rise.
Conforming Mortgage vs. Jumbo Mortgage
Most of the mortgage loans are eventually purchased by Fannie Mae and Freddie Mac and they set the loan limit on a mortgage under which they will purchase from a lender as a conforming loan. The current conforming loan limit for a mortgage of a single-family house is $417,000. When the amount a borrower takes in a loan exceeds the limit, the mortgage is considered a jumbo mortgage and usually carries a higher interest rate.
Mortgage Loans of Different Amortization
Fully Amortized Mortgage Loan
The classic example of fully amortized loans are fixed-rate loans, as they are fully paid off at the end of a loan term based on a normal amortization schedule.
Interest Only Mortgage Loan
For a pre-determined period of time (typically ten years), borrowers may be allowed to cover only the interest with a lowered monthly payment to meet certain initial loan requirements. During the period, the principle of the loan is not paid down at all. Later when total principle is spread over a shorter period of time, payments may rise steeply. A borrower needs to understand that they aren’t building equity in their home during the interest-only period.
Balloon Mortgage Loan
Payments on a balloon mortgage loan do not cover its fully amortized amount each period and at the end of the loan term, the unpaid balance must be repaid in a lump sum. A good example would be that a 7-year loan is amortized over a 30-year period and each of the scheduled payment covers maybe interest and only part of the principle. Refinance is often the option at the end of a balloon mortgage loan.
Negative Amortization Mortgage loan
When a loan payment does not even cover the interest, the unpaid interest is added on top of the principle. As a result, over time the borrower would owe more than on the loan than what was originally borrowed. Negative amortization happens, for example, when there is a payment cap but not an interest rate cap, allowing interest charge to exceed the payment made.
Flexible Payment Mortgage Loan
These mortgage loans allow the choice of the amount of payment by borrowers. One that is mostly often referred to is the option ARM. Borrowers can get as many as four payment options to choose from each month: a minimum payment, an interest-only payment, a 30-year amortized payment, or a 15-year amortized payment.
Biweekly/Bimonthly Mortgage Loan
These loans are aimed at increasing the frequency of loan payments in order to shorten the loan term to save on interests.
Buying a home may very well be one of the biggest financial decisions of your life. It’s important that you understand the different types of mortgage loans that are out there and find one that fits your financial needs. Picking the wrong type of mortgage can lead to tons more interest, less equity in your home, or even financial ruin!