An Explanation of Mortgages
Mortgages can be confusing, mostly because there are so many variations. Choosing which variation is best for your situation is the ultimate goal.
First, let's lay some groundwork — there are two categories of mortgages: the fixed-rate and the adjustable-rate mortgage (ARM). From those, there are multiple variations which you can select that suit your finances and lifestyle. It's important to note that each mortgage variation has it's risks, benefits, and drawbacks. Weighing the risks, benefits and drawbacks of each mortgage variation is what will determine which is best for your situation.
Another type of mortgage is the reverse mortgage, but this only applies to those over the age of 62. A reverse mortgage allows seniors to convert equity in their home into income.
The 30-year fixed-rate mortgage
The staple of the industry, the 30-year fixed rate is the most common home loan. This type of mortgage allows you to pay a fixed payment each month for 30 years.
The benefits to a 30-year fixed-rate mortgage is knowing the mortgage payment will not change, regardless of interest rate changes. The drawback of this mortgage is if the interest rates drop, you are still paying the higher rate since your rate is locked in.
The 15-year fixed-rate mortgage
The 15 year mortgage is similar to the 30 year, but you will pay off the mortgage in half the time. Since the term (i.e. time in months) is shorter, you will pay less interest, usually less than half the total interest of a 30-year fixed-rate loan. However, the monthly payments are higher than those of a 30-year mortgage. If you can afford a higher monthly payment, you may want to consider a 15 year mortgage.
Fixed-rate balloon mortgage
If you are not planning to stay at the home for a long period of time, a Fixed-rate balloon mortgage may be a good choice. Starting with relatively low, fixed payments, a fixed-rate balloon mortgage usually is only for five to seven years with a single payment (the "balloon") for all the remaining principal due at the end of the term. You may have the option to refinance the balloon to a fixed-rate "short-term" loan. Since the term is short, the total interest paid is significantly less than a conventional mortgage if the home is sold before the balloon payment comes due.
A fixed-rate balloon mortgage isn't for everyone. There are more risks involved. If you cannot make the balloon payment, and cannot sell the house while paying off the short-term balloon payment refinance, you may be in for some troubling financial times.
The adjustable-rate mortgage (ARM)
Adjustable-rate mortgages generally offer lower interest rates and mortgage payments during the early term of the loan, but since interest rates do change, you assume the risk of interest rates rising. Usually you will choose an ARM because the lower initial payments make the home more affordable — at first — but you must be willing to accept the risk of interest rates rising which will cause your mortgage payment to also rise.
The interest rates on ARMs are adjusted based on changes to a specific interest rate index, like the U.S. treasury bill rate. These adjustments will occur at times specified in the ARM disclosure you receive from the lender. There will always be a floor cap, payment cap, and life cap on the rate. It's important to understand ARMs before signing the papers.
Hybrid ARM
There are two types of hybrid loans: those that begin as a fixed-rate loan and convert to an ARM and those that begin as an ARM and convert to a fixed rate.
The first type offers a fixed-rate mortgage at a lower rate for an initial period, such as two, three, five, seven or 10 years. The ARM starts as a fixed-rate mortgage, then converts to a one-year adjustable ARM at the prevailing interest rate, plus an additional amount or margin. The adjustment from the fixed-rate period to the ARM and subsequent adjustments can result in significant mortgage payment increases at each stage. The rate is capped at specified amount, so mortgage payments will stop increasing when the rate cap is reached.
Two-step mortgage
This type of mortgage is a hybrid ARM that offers a fixed rate for a set time and adjusts only once—usually at five or seven years. After that the interest rate is adjusted to market conditions at the time.
Convertible ARM
A convertible ARM is a hybrid ARM that allows you to start with a lower-rate ARM and convert to a 30-year fixed loan at a specified conversion rate. In other words, at a specified time, the rate stops adjusting and remains the same for the rest of the loan. However, if the interest rate is at a higher level when it’s time to convert, you may not want to do it. In that case, the loan would become a regular ARM, which would continue to adjust. A convertible mortgage enables you to have initially lower payments with the option to make it a fixed-rate mortgage at the time of conversion, when payments could go up. Borrowers must be confident that if they stay in the home, they can afford higher monthly payments after the lower-rate period ends. There is usually a fee to be paid when the loan converts, and the rate can be slightly higher than the going rate for fixed-rate loans.
Payment-option ARM
This type of loan offers some flexibility, but that flexibility can be costly if you don't fully understand what you are getting. For a period of X number of years, you can choose the type of payment made each month. Typically, there are four options:
- a minimum payment that "does not" cover interest — this option "increases" the total loan balance
- an "interest-only" payment that "does not" reduce the total loan balance
- a payment of interest and principal that pays off the mortgage in 30 years
- a payment of interest and principal that pays off the mortgage in 15 years
After the option period, mortgage payments increase, and if you chose to make only the minimum payments that do not cover the interest on the loan, payments may increase before the option period ends. The unpaid interest is added to the balance of the loan so the loan balance goes up, not down, otherwise known as "negative amortization." When the loan balance reaches a certain specified amount, the payments will go up regardless of when the option period ends. You then begin making significantly higher payments to lower the loan balance. Paying only minimum payments can increase the amount that is owed to the point where you owe more than the home is worth.
The 2/28 adjustable-rate mortgage
A 2/28 (3/27, etc.) ARM is a type of hybrid adjustable-rate mortgage in which the rate is fixed at a higher rate than the fully indexed rate for the first two years, then adjusts for each of the next 28 years, unless refinanced, to the value of a rate index at that time, plus a margin . The margins can be high, so the payment almost always goes up even if market rates are the same or lower.
Mortgages allowing interest-only payments
An interest-only option can be a feature of any type of loan; however, it is typically available only for a limited time, after which payments go up — sharply. Paying only the interest enables you to make lower payments without increasing your loan balance. At the same time, however, the balance does not decrease and you do not build equity unless the home goes up in value. If the house value doesn’t go up, you may owe money if you sell. In most cases, you can make principal payments at any time during the interest-only period.
Low- or no-documentation loan
This type of loan is only for those who have trouble verifying all of their income. These usually include the self-employed, commissioned professionals, or service-industry professionals who rely on tips for a substantial part of their income. The lender does not require proof of income and assets. No debt-to-income ratio or housing-to-income ratios are considered. In exchange, the interest rate will be significantly higher since the lender is assuming a higher risk of default. In addition, a larger downpayment will more than likely be required, and your credit score will need to be very high (i.e. 700+).
Loans with pre-payment penalties
A pre-payment penalty can be part of any type of loan. Check with the lender to determine whether the loan you want carries this type of penalty. However, loans with these penalties may offer initially lower payments in exchange for a promise to pay a specified lump sum if the borrower refinances the date specified in the mortgage agreement.
Reverse mortgage
A reverse mortgage is a special type of home loan that lets a homeowner over the age of 62 convert a portion of the equity in their primary residence into income. These mortgages have become increasingly popular as more baby boomers enter or near retirement and also because they offer seniors an option to pay for a variety of expenses. The reverse mortgages loans are secured by the home and the owner does not have to repay the loan until they die, sell or premanently move out of the home. The amount paid is based on the homeowner's age. The older you are, the more you are paid.
Buydown mortgage
This type of mortgage enables you to get a lower interest rate by paying a lump-sum fee or by paying a fee that is financed over the life of the loan. Buydowns are similar to paying "points", but they usually are paid by the seller or the builder as an incentive to make a sale by creating lower monthly payments. Be aware that the cost of those points may be included in the selling price, and you could end up paying more for a house than its appraised value.
There are two types of buydowns, temporary and permanent. A temporary buydown lowers the monthly payments, and the interest rate for the first few years of the loan. The most common type of temporary buydown is the "3-2-1" buydown. For example, an 8 percent loan with a 3-2-1 buydown would have a 5-percent interest rate the first year, a 6-percent interest rate the second year, a 7-percent interest rate the third year, and an 8-percent interest rate beginning the fourth year through the life of the loan. This type of buydown will generally cost three to four points – that’s $6,000 to $8,000 on a $100,000 loan. A permanent buydown lowers the interest rate for the life of the loan. Again, this type of buydown will generally cost six to eight points and may reduce the interest rate by only 1 percent for the life of the loan.
