When it comes to buying a home, you need to know about your mortgage options. What you’ll discover is that there are four types of mortgage loans. They include fixed rate, adjustable rate, interest only, and balloon. And for each type there will be a variety of terms and options that lenders will offer. But once you understand the big picture, you’ll be able to determine the best type of mortgage loan for your financial situation.
Fixed Interest Rate Mortgage
The fixed rate mortgage is the most common and well-known choice, probably because it’s been around the longest. When the rate is “fixed” it means that it will never change over the life of the loan. So, if you lock into a fixed rate of 5% today, it’ll be the same in 20 or 30 years, unless you decide to refinance your home sooner at a different rate.
A fixed rate also means that your monthly mortgage payments (principal + interest) will be the same each month. When you start making your mortgage payments, most of it will be in interest. Lets walk through an example so that you can see how it works. Click here for a mortgage calculator if you want to play with your own numbers.
If you lock into a $165,000 mortgage loan with a rate of 5%, your monthly payment would be $885.76.
If you breakdown this amount, you’ll pay $687.50 in interest and $198.26 will go toward paying down the principal. In fact, you’ll be paying over $600 in interest every month for the first 7 years of the loan.
Of course, over time the ratio will gradually flip with bigger chunks of your payments going toward paying down the principal. But remember this. You won’t own the home outright until all the principal is paid off. In this example, it’s the $165,000.
Now, when it comes to the time-length of mortgage loans, you can find arrangements that last 30 years, which is the most popular, but there’s also 20 years, 15 years, and 10 years. So the shorter the length of your loan, the less you’ll pay in interest and the faster you’ll pay off the principal.
For example, if you finance the same $165,000 at 5% over 15 years, your monthly payments will be $1,304.81. But the split between principal and interest will look significantly different. In this case, right from the beginning, the interest amount will be $687.50, but the principal will be a hefty $617.31. This means that the loan will get paid off a lot faster.
Adjustable Rate Mortgage
An adjustable rate mortgage or ARM differs from a fixed rate mortgage because the interest rate on the loan will gradually increase (or sometimes decrease) every year or two. You may also see adjustable rate loans referred to as variable rate loans.
These types of mortgage loans almost always start out with introductory rates that are lower than fixed rate mortgages. That’s what makes them attractive to many people. And while your rate will rise over time, the loan terms usually include a cap or maximum rate that you can be charged over the life of the loan. For example, the beginning rate might be 3% with a cap clause that says the rate increase cannot exceed more than 2 percentage points per year, and the maximum rate for the loan can never be more than 8%.
The rates can be determined in a variety of ways. Some lenders will come up with their own rates, and the timing of increases, at their own discretion. But then other mortgage lenders may loosely tie their adjustable rates to an interest rate index or to what a particular federal government agency is charging on its loans. You’ll want to discuss the calculation with the loan officer, and ask how often your rate will increase and by how much.
Now, it shouldn’t surprise you that there are different types of adjustable rate mortgages. For example, there is the Hybrid ARM. Under the terms of this type of mortgage loan, your initial interest rate would be fixed for a period time, such as 3 years, and then it would gradually increase each year.
Next, there is the Option ARM. With this type of loan, you would get to choose between four payment options for a period of time.
For example, the payment could be an agreed upon minimum amount. Or, it could treated like an interest-only loan (discussed below), or the monthly payment could be the equivalent of what you’d pay on a 15 year or 30 year loan. Anyway, after the initial period is over, the loan rate would rise just like any other ARM.
When you start looking into Option ARMs, you’d be wise to know exactly what you’re getting into and the potential financial impact. Beginners should probably steer clear.
An interest only mortgage loan is a cross between an ARM and fixed rate mortgage. Initially, you would only pay the interest portion of the loan for a set number of years at a fixed rate. And then after that period, the loan would reset to a new rate which would likely be higher. So during this timeframe, no money will go toward paying down the principal. It’s almost like you’re renting.
Let’s go back to our mortgage loan example discussed under the Fixed Interest Rate Mortgage section. As you may recall, the loan amount was $165,000, the interest rate was 5%, and the monthly payment was $885.76.
If this was translated into an interest-only mortgage, the terms might say something like, “This is a 30-year mortgage, of which the first 5 years will have a fixed rate of 5%. Then, the new rate starting in year six will be 7%”.
So under this arrangement, you would only pay the interest amount of $687.50 per month for the first 5 years. After the initial period, your monthly payments will increase significantly. Click here to use an interest only calculator if you want to try different amounts.
This is one of the loan types that got a lot of people in trouble during the real estate collapse that began around 2006. The low interest-only mortgage payments got them into their homes. However, the combination of ballooning mortgage payments, falling home values, and rising unemployment devastated many homeowners and forced them out of their homes.
Nevertheless, this is an option for getting into a home if you can only barely afford it, but anticipate that your income will be rising consistently in the coming years. Just be aware of the delicate game you’re playing.
When you apply for a balloon mortgage, you would go through the same application process as you would for a standard 30 year mortgage loan. If fact, your monthly payments will be same as that of someone who applied for a mortgage, without the balloon feature. As such, your payments will consist of principal and interest.
But the special terms of the balloon mortgage would state that after 5 or 7 years, you agree to pay off the remaining outstanding loan balance in full. The outstanding amount that comes due represents the “balloon”.
Suffice it to say that after the initial 5 or 7 years, you’ll have to come up with the balloon payment through refinancing the mortgage or some other means. If you don’t, your home will be foreclosed by the bank. And even if you do refinance, mortgage rates could be higher.
The reason that someone might want to get a balloon mortgage is because they don’t expect to live in the home for very long and will put it up for sale in the near future.
Now, in case you’re wondering about some of the differences between balloon mortgages versus interest-only mortgages and adjustable rate mortgages, I’ll briefly touch on some key areas. First, you could actually consider an interest-only mortgage a type of balloon mortgage. But one big difference is that with a true balloon mortgage, your monthly payments will consist of principal and interest rather than simply 100% interest.
Second, an adjustable rate mortgage can start with a fixed interest rate that will remain unchanged for several years. But the terms of the mortgage will permit the lender to adjust the rate periodically (usually upward). This is different from balloon mortgages which generally don’t have adjustable rates. You would simply go into the marketplace and apply for a new loan at the current rate. This rate could be higher or lower than what your rate under the adjustable rate mortgage terms might be.
In conclusion, the different types of mortgage loans were created to meet the needs of home buyers facing a variety of financial situations. However, the biggest driver for choosing a loan will probably be your income. If your income is solid and you’re not carry much debt, then a fixed rate mortgage will usually be the best option.
But if you’re trying to buy a home that challenges your budget, then an adjustable rate or interest-only mortgage loan would be better. And if you’re dealing with a temporary situation, a balloon mortgage may be all you need.
My only advice is that if you decide to go with an adjustable rate or interest-only mortgage, be confident that your income will be rising sooner rather than later.
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