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.
Just in case you wondered..
1. Mortgage is Related to Death
The word mortgage stems from the Old French word ”morgage,” or “mort gaige,” which means “dead pledge.” Your mortgage dies once you pay it off or fail to make payments.
2. The First Use of the Word Had Nothing to Do With Housing
The earliest use of the word mortgage (spelled morgage) was in the poem Confessio Amantis, which was written in the 1300s. In that poem, the word was used to describe marriage, not a home loan.
3. The American Mortgage Has Changed Over Time
Thirty-year mortgages are a relatively new thing. In the time before the Great Depression, mortgages had short maturity times and usually required a very high down payment, according to “The American Mortgage in Historical and International Context.” Pre-Depression mortgages featured variable interest rates and were usually renegotiated on a yearly basis.
4. Plenty of People Are Clueless About Mortgages
According to CNN Money, more than a third of people surveyed had no idea what “annual percentage rate” meant and more than a third thought that lenders were required to charge the same fees to each customer. The truth is that your lender can charge you whatever it wants for your credit check and appraisal. That’s why I recommend shopping around when looking for a mortgage.
5. 30-Year Fixed Rates are the Lowest They’ve Been
While interest rates are expected to climb this year, they are still at an all-time low. When fixed-rate mortgages were first offered in 1971, rates were around 7.5 percent, according to Freddie Mac. Around 1980, they jumped to nearly 20 percent. Today, they’re just under 5 percent.
6. A Red Door Means Mortgage-Free
Some mortgage facts are just plain fun. For example, in Scotland, people paint the front door of their house red once they’ve finally paid off the mortgage. You might want to invest in a bucket of red paint for when that day comes.
7. There’s a Lot of Mortgage Debt
The total mortgage debt outstanding at the end of the third quarter of 2013 was more than $13 trillion, according to the Federal Reserve. The type of property with the most mortgage debt in 2013 was one-to-four-family residences.
8. There Are Fewer First-Time Buyers
Usually, first-time buyers make up 40 percent of the housing market. But recently, that number’s been lower. In 2013, 38 percent of buyers were buying for the first time, according to the National Association of Realtors (NAR).
9. Mortgages Are Pretty Common
According to NAR, 88 percent of buyers take out a mortgage to pay for their home. Most buyers financed 90 percent of the cost of the home, meaning they paid a down payment of 10 percent.
10. Skipping Down Payments Is Still Possible But Not As Common
The number of people who financed a home without a down payment peaked in 2007 for first-time buyers, just before the housing crisis. The number peaked in 2009, at 16 percent, for all buyers. Today, about 12 percent of all buyers don’t put any money down, which might be surprising to some.
11. The History of Freddie and Fannie
Fannie Mae dates back to 1938 and was created by President Franklin Roosevelt to free up money for lenders, according to Time. Freddie Mac was created in 1970, just after Fannie Mae became a publicly traded company. I don’t think the government ever anticipated the two organizations becoming as large as they are now. Today, Freddie and Fannie combined own or guarantee about half of the mortgages in the country.
12. In Some Countries, a Mortgage Can Be More Than the Home’s Value
In the U.S., the maximum value of a mortgage is typically 97 percent of the home’s value, though as I mentioned, you can get a mortgage for 100 percent of the value of the house. In the Netherlands, a borrower can take out a loan for as much as 115 percent of the home’s value, while in the U.K., people can borrow up to 110 percent of the value.
13. France Is a Friendly Place for Mortgages
Mortgages aren’t as common in France as they are in other countries. French mortgages make up just 25 percent of the country’s gross domestic product, for example. But most mortgages there come with a fixed rate and no pre-payment penalty.
14. The Mortgage Interest Deduction Has a Long History
When the idea of an income tax was first created in 1894, all types of interest were deductible. Things started to change in the 1970s when credit cards became much more common. In 1986, mortgage interest became one of the few types of interest you can deduct from your taxes. People debate whether the deduction is any good, as only about 50 percent of all homeowners take it, according to the New York Times.