Mortgage Types Explained
Not every home buyer and borrower is the same. As such, there are plenty of mortgage programs available out there to meet the needs of various types of borrowers with very different financial backgrounds and needs.
The decision about which type of mortgage you choose is an important one. It’s essential to make sure you understand all your options before making the selection on which mortgage type is right for you.
The most popular type of mortgage is the fixed-rate mortgage. With this option, the interest rate is locked in and will remain the same throughout the duration of the term. Fixed-rate mortgages allow borrowers to make the same payment every month without having to worry about any fluctuations in their given interest rate.
It’s important to note, however, that the rate is only locked in and guaranteed for the term, and not the entire amortization period of the mortgage. For instance, if you agree to a 30-year mortgage with a 5-year term, your rate is locked in only for that 5-year period. Once the term expires, you’ll need to renegotiate a new rate at a new term, or opt for a completely different type of mortgage altogether.
The trade-off for such predictability is that these mortgages can often come with higher closing costs. In addition, they can be a little more challenging to get approved for versus some other types of mortgages. However, despite these disadvantages, obtaining a fixed-rate mortgage can make sense for many buyers, particularly first-timers.
Contrary to the fixed-rate mortgage, an adjustable-rate mortgage (ARM) comes with an interest rate that fluctuates as the market dictates. This type of loan traditionally starts off with a low rate and adjusts over time. With ARMs, the rate will change during the term of the mortgage.
Generally speaking, such mortgages are initially set up like a standard loan based on the present interest rate. At regular intervals, the mortgage is reviewed, and should the market interest rate change, the lender will adjust the mortgage repayment plan accordingly. This can be done either by changing the length of the amortization period, the size of the payment, or a combination of both.
A popular variety of an adjustable-rate mortgage these days is the “hybrid ARM,” in which a certain interest rate is guaranteed to stay fixed for a certain time. This initial interest rate is often lower than what you would traditionally be offered with a traditional 30-year fixed loan.
A conventional - or conforming - mortgage is one that is not insured by the federal government, which means no guarantees are made to the lender should the borrower default on the mortgage payments. As such, they are considered higher risk for lenders. For this reason, borrowers typically need to have a high credit score, a healthy financial history, and a low debt-to-income ratio in order to get approved for a conventional loan.
If less than 20% is put towards a down payment, Freddie Mac and Fannie Mae guidelines stipulate that the lender needs to bring on a private insurer for the loan. Such Private Mortgage insurance (PMI) must be paid for by the borrower. However, once the borrower has paid down at least 20% of the property’s purchase price, payments for PMI will cease.
These types of mortgages follow the guidelines set by Fannie Mae and Freddie Mac, and may either be fixed- or adjustable-rate mortgages.
For those who don’t meet the stringent requirements to get approved for a conventional loan, there are government-backed loan options available, such as FHA loans. These mortgages, which are guaranteed by the Federal Housing Administration, get a lot of attention from first-time home buyers and borrowers with less-than-perfect credit because of their more attractive features and easier lending requirements.
FHA mortgages offer low down payment requirements for those who may be unable to gather a large lump sum of money to put towards their home purchase. While the minimum down payment for a conventional mortgage is 5% of the purchase price of a home, FHA mortgages allow buyers to put down as little as 3.5%.
It should be noted that the Federal Housing Administration doesn’t actually issue the loans. Instead, it supports lenders should borrowers default on the mortgage payments.
Some borrowers choose an interest-only mortgage in an effort to keep their payments as low as possible. A mortgage is considered “interest only” if the monthly mortgage payments consist only of interest. This option lasts for a specified period, typically 5 to 10 years. Borrowers can pay more than interest if they choose to. No principle portion is paid, which means the only way equity can be built up during this interest-only time period is through appreciation.
By only being temporarily responsible for paying the interest portion, monthly payments are substantially less. It’s important to note, however, that reducing monthly mortgage payments will increase the overall interest that will need to be paid over the life of the mortgage, and lowers the amount of home equity that will be gained. That’s why such an option should only be temporary in nature.
Home Equity Loans
Also referred to as second mortgages, home equity loans allow homeowners to borrow money against the equity already built up in the home. They are an attractive option for those who need to cover a large expense, such as a major home renovation where a large sum of money is required up front. With these types of loans, homeowners can borrow up to $100,000 of equity and still be able to deduct all of the interest upon filing their tax returns.
There are two types of home equity loans: fixed-rate loans and lines of credit. Both of these variations typically range from 5 to 15 years, and must be repaid in full when the home is sold.
The fixed-rate variation offers a single lump sum of money to the homeowner, which then needs to be repaid over a certain time period at a specific interest rate.
With a home equity line of credit (HELOC), homeowners can borrow against the equity in their homes similar to the way a credit card works. They are allowed to borrow a set limit, and can withdraw as little or as much as needed at any time, as long as this limit is not exceeded. Only the amount withdrawn is charged interest, and once the money is repaid, it can be borrowed again and again until the end of the loan term is reached.