Basically, there are two categories of mortgages: the fixed-rate and the adjustable-rate mortgage (ARM). Within these categories, there are many variations. However, in nearly all mortgages two factors are usually at odds: how predictable the payments are and how low, or affordable, they are at least initially.
The 30-year fixed-rate mortgage
Not long ago, there was only one kind of mortgage: 30-year fixed rate (the borrower has 30 years to pay back the mortgage at a fixed interest rate and the payments are the same over the life of the loan). It is still the most common home loan.
Borrowers choose fixed-rate loans because the mortgage payments are steady and predictable, allowing for easier household budgeting and planning. The payments are the same over the life of the mortgage, regardless of interest rate changes. Initially, both the rate and mortgage payment are higher than those of an adjustable-rate mortgage, but the payment is lower than that of a 15-year fixed-rate mortgage (see below). People who choose a fixed-rate mortgage usually are planning to keep their home and mortgage for several years.
The 15-year fixed-rate mortgage
This type of mortgage enables you to own your home in half the usual time, meaning you could possibly own it before your children start college or you reach retirement. Because the loan is shorter, you pay substantially less in the total interest over the life of the loan, often less than half the total interest of a 30-year fixed-rate loan. However, because the term is shorter, the monthly payments are higher than those of a 30-year mortgage. For people who can afford the higher monthly payments, this is an excellent choice, with lower total costs and a shorter term. Qualification for this type of loan may be more difficult because the income requirement may be higher.
This is a special kind of fixed-rate mortgage that offers relatively low, fixed payments as though it were a standard 30-year fixed-rate mortgage. After a few years-usually five to seven years-the mortgage term ends with a single large payment (the "balloon") for all the remaining principal. Borrowers generally have the option to refinance their balloon mortgage to a fixed-rate loan at the end of the term. The balloon is considered a short-term loan that offers rates and steady payments that are usually lower than those of conventional fixed-rate mortgages. Because the term is quite short, the total interest paid is significantly less than a conventional mortgage if the house is sold before the balloon payment comes due.
People who choose this type of mortgage usually don't plan to stay in the home for very long and expect it to appreciate in value quickly. They expect to sell it before the maturity date when the balloon payment is due, but if they do not sell, they must refinance because all remaining principal is due. If they do refinance, they take the risk that interest rates may be much higher than when they got the balloon loan. If the house doesn't appreciate as expected, the owners may end up owing all remaining principal plus additional settlement costs if they sell after the balance is due.
The adjustable-rate mortgage (ARM)
In general, adjustable-rate mortgages can offer lower interest rates and mortgage payments at first because the borrower assumes the risk of changes in interest rates. Usually borrowers choose ARMs because the lower initial payment makes the home more affordable at first, but the borrower must be willing to accept the risk of an increased mortgage payment, which can sometimes be significantly higher.
After a specified period of time, the interest rate and payments on an ARM are adjusted based on changes to a specific interest rate index (such as the U.S. treasury bill rate). These adjustments occur at times specified in the ARM disclosure you receive from the lender and can result in payment increases. There is always a floor cap, payment cap, and life cap on the rate. It's important to understand all the aspects of ARMs before you make your decision.
People who choose an ARM usually are intending to sell or refinance before the rate adjusts upward. They also may expect income to increase over time. These borrowers must be confident they could afford the post-adjustment higher payments if they cannot refinance or sell.
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 of hybrid ARM offers the predictability of a fixed-rate mortgage at a lower rate for an initial specified period, such as two, three, five, seven or 10 years. This 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.
People who choose this type of hybrid ARM usually want a predictable payment for a period of time and plan to refinance or move before the rate adjustment. Borrowers must be confident that if they stay in the home, they can afford higher monthly payments after the fixed-rate period ends.
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.
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.
This type of loan offers flexibility and choices but can be costly if the buyer does not fully understand all the options. For a period of years - this period is spelled out in the mortgage - borrowers 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 doesn't 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. In some cases, payments may increase before the option period ends. This happens when borrowers choose to make only the minimum payments that do not cover the interest on the loan; the unpaid interest is added to the balance of the loan so the loan balance actually goes up instead of down; this is 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. Borrowers then must 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 the borrower owes more than the home is worth.
People who choose a payment-option ARM usually want flexibility in making payments and may have an income that is uneven over the year. Common examples are commissioned salespeople who may receive their income in a few large and unpredictable disbursements over the course of a year, as opposed to a steady monthly or bi-weekly paycheck. These borrowers must have sufficient income to cover adjustments, and they often plan to refinance or move before any uncomfortable adjustment occurs.
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 . These margins can be high, so the payment almost always goes up even if market rates are the same or lower. For example, the rate is 8 percent for two years and the index is currently 4 percent, but the margin at the end of two years is 6 percent. Even if the index remains at 4 percent after two years, the loan rate will jump to 10 percent.
These loans often are offered to borrowers with lower credit scores who may not qualify for a conventional loan. The idea is to give these borrowers two years to rebuild their credit and become eligible to refinance at a better rate. These borrowers may avoid PMI (see What's in a Mortgage Payment ?) because often the two-year ARM is for 80 percent of the sales price and is combined with a loan on the other 20 percent that usually has a fixed rate with a balloon payment. This enables borrowers to finance 100 percent of the loan (but not the closing costs.) Those who get a 2/28 usually plan to refinance in two years, but it is important to make sure the prepayment penalty does not run past the two-year mark.
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.
People who choose a mortgage allowing interest-only payments usually are those who plan to move (or less often, refinance) before the interest-only period ends; expect their income to increase sharply; receive large bonuses at certain times of the year; or reasonably expect the value of the house to rise sharply. They must budget wisely and be willing to make lump-sum payments, steering clear of using that money for other purposes. These borrowers must be confident that if they do remain in the home or cannot refinance, they could afford the higher monthly payments. At the end of the fixed period, you must refinance, pay a lump sum or start paying on the principal.
Low- or no-documentation loan
This type of loan is only for those who have trouble verifying all of their income. These usually include self-employed borrowers, commissioned professionals, or service-industry professionals (bartenders, waitresses, hair stylists, etc.) who rely on tips for a substantial part of their income. The lender does not require proof of income and assets. No ratios (debt-to-income or housing-to-income) are considered. The interest rate can be significantly higher because the lender is assuming a higher risk of default. A larger downpayment also may be required, the and credit score usually must be very high.
Loans with pre-payment penalties
A pre-payment penalty can be part of any type of loan, so you should check with the lender to find out 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.
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" (see All About Interest Rates ), 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 interest rate and the monthly payments 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.