Choose the Right Mortgage for You

Jeanette A. Tucker, Attaway, Denise  |  4/11/2007 7:09:19 PM

There are many different types of mortgages a person can get when buying or building a home. Some people decide for themselves what type of mortgage best suits their needs. But, if you’d rather have a professional’s advice, you should consult a mortgage counselor.

Here are some types of mortgages you may consider:

Fixed Rate Mortgages
 
A fixed rate mortgage carries an interest rate that will be set at or before the time of the loan and remain constant for the length of the mortgage. If you have a 30-year mortgage, the rate you pay will be fixed for all 30 years.

The big advantage to borrowers is that the rate will remain constant, and the monthly payment he or she must make will remain the same. This reduces the risk that the borrower may be called upon to make higher interest payments than he or she counted on. The tradeoff is that the lender is taking the risk that interest rates will rise, and, thus, the lender will get stuck carrying a loan at below market interest rates for much of the 30 years. As a result, lenders may charge a higher interest rate on a fixed rate loan -- which means higher monthly payments -- than the initial rate and payments on adjustable or balloon mortgages.

If you want a predictable monthly payment and plan to live in the property for more than 10 years, this is a good choice of mortgages. (TOP)

Adjustable Rate Mortgages

An adjustable rate mortgage (often called an "ARM") offers a fixed initial interest rate and a fixed initial monthly payment. However, both are "fixed" not for the life of the loan, but for a much shorter period of time, often six months to five years. With an ARM, after the initial fixed period, both the interest rate and the monthly payments adjust on a regular basis to reflect the then current market interest rates based on an index. (Each lender can use its own index and formula, and some may be more or less advantageous to borrowers.)

Each lender may also use different adjustment periods. For example, some ARMs may be subject to adjustment every three or six months while others may be adjusted just once a year. In addition, some ARMs limit the amount that the rates can increase (or decrease) on any adjustment, perhaps to no more than one-half of 1 percent on any adjustment date. An ARM usually carries a lower initial interest rate and lower initial monthly payment for the buyer in exchange for the buyer taking the risk that rates may rise in the future, which would mean both the rate and monthly payments will adjust upwards.

As an inducement to bring in new borrowers, some lenders may offer low "teaser" introductory rates, a discounted rate — for up to 12 months of a loan and thereafter jump to the actual rate of the loan (along with a corresponding payment adjustment). Most ARMs also carry an "interest-rate cap," which is an upper limit on the rate that may be charged the homeowner.

For example, suppose the initial rate on your loan is 6 percent and the cap is 11 percent, and rates climbed to 15 percent. The maximum interest rate that could be charged on the loan would be 11 percent. Payment caps, in contrast, limit the amount by which the payment can vary on an ARM. Having a loan with a payment cap but without an equivalent interest-rate cap is an invitation to negative amortization, which occurs when monthly payments are actually smaller than necessary to pay the interest. This practice will result in a principal loan balance that rises, rather than falls.

Borrowers with ARMs should always determine the “worst case” scenario for interest rate increases under their loan contract and calculate the monthly payment that would result. With an ARM, the risk of interest rate changes is assumed by the borrower, not the lender.

If you anticipate an increase in your income, you may be able to afford the potential increase in the rate and your monthly payments with an ARM. An ARM is a good idea if you plan to sell your home before the first rate adjustment.(TOP)

Balloon Mortgages

A balloon mortgage has a fixed interest rate and fixed monthly payment, but after a fixed period of time, such as five years, the entire balance of the loan becomes due at once. As a practical matter, the homeowner is unlikely to have enough cash to pay off the entire loan balance after five years, so s/he will then have to go out and arrange a new mortgage. If he or she can’t get another mortgage, he or she is stuck and may lose the house. Balloon mortgages are usually a last resort for those who can’t qualify for a standard fixed or adjustable rate mortgage.

If you are ready to refinance at the end of the balloon term with potentially higher interest rates, you can risk the balloon loan. As a first-time home buyer, you might make a better choice by avoiding the risks associated with balloon loans. (TOP)

Home Equity Loans

This is another type of mortgage typically used by homeowners to borrow some of the equity they have built up in their homes. Homeowners who get a home equity loan usually involve a "floating" or adjustable rate of interest that is amortized over a period of years. (TOP)

Biweekly Mortgages

Companies who offer this type of mortgage automatically debit your checking account every two weeks, and then place this money in a trust account. This trust account is a holding account for your money. When your payment is due, the money is withdrawn from the trust account and forwarded to your lender. Because you are placing funds in the trust account quicker than your monthly payments are due, you eventually accumulate enough money to make an extra payment. The extra payment is applied directly to your principal balance, which causes your loan to amortize faster and allows you to pay off your loan more quickly. Under a biweekly repayment plan, a 30-year mortgage loan may be repaid in approximately 20 years.(TOP)

Reverse Mortgages

A reverse mortgage is a special type of private home loan that lets homeowners convert the equity in a home into cash. Unlike conventional mortgages, the reverse mortgage allows eligible homeowners (typically those 62 years of age or older) to borrow against the value of their home. The contract allows the owner(s) to continue living in the home. The equity built up over years is paid by the lender in return for either a fixed monthly income, a line of credit that can be drawn upon at the option of the homeowner, or possibly a lump sum. Unlike a traditional home equity loan or second mortgage, no repayment is due, under most plans, until the last surviving owner sells the house, moves out permanently, or dies. (TOP)

Interest-only Mortgages

Interest-only means only interest is paid in the first few years of the mortgage without reducing the principal. This may sound attractive but it is really costly if the borrower keeps the home for very long.

For example if a mortgage has an interest-only period of five years in a 30-year term mortgage, after five years of paying interest alone the borrower has to pay principal and interest for the remaining 25 years. The amount saved by not paying the principal for the first five years is far less than the extra amount the borrower pays for the remaining 25 years.

If you anticipate the value of your home to increase dramatically and you plan to move in three to five years, you may consider an interest-only mortgage.

These are just some of the types of mortgages offered by lenders today. For more information, consult a mortgage counselor, or search for “mortgage” information on the web. (TOP)

First-time Buyer Programs

Many lenders offer affordable mortgage choices geared toward first-time home buyers. These choices clear the obstacles that made purchasing a home more difficult in the past. First-time buyer programs can help borrowers who have not saved a lot of money for the down payment and closing costs, have a poor credit history or no history at all, have quite a bit of long-term debt or have an unstable income. If you are a first-time homebuyer, find out whether you are eligible for this type of program and ask lenders about income and home-value limitations. (TOP)

FHA Loans

These loans are insured by the Federal Housing Administration (FHA) and made by an approved lender in accordance with the FHA's regulations.

These loans typically require a smaller down payment than a conventional loan. The FHA does not lend money; it simply approves and insures loans through sponsored lenders. (TOP)

VA Loans

A VA loan is a loan guaranteed by the Department of Veterans Affairs. It is also referred to as a "government" mortgage. These loans are made to honorably discharged veterans or their widows or widowers. Such loans require a minimal or no down payment and offer lower interest rates. (TOP)

Reference: Garman, E.T. & Forgue, R.E. (2006). Personal Finance. Boston: Houghton-Mifflin Co.
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