Mortgage Loan Types
Fixed-rate mortgages have been the mainstay of the home loan industry for decades. Over the years, loan-to-value ratios have fluctuated and interest rates have moved up and down, but the security a fixed-rate mortgage offers has never lost its appeal.
The word “mortgage” comes from the French. Mort means dead and gage means pledge. It’s been argued that if the mortgagor (borrower) did not pay the debt, the property was dead to the owner because the mortgagee (lender) would reclaim the land used as security.
If the debt was paid, then the pledge was dead. But those funny, silly French. Who really knows what it originally meant back in the 1500s?
What is a Fixed-Rate Mortgage?
Fixed-rate mortgages allow for repayment of a debt in equal monthly mortgage payments over a specified period of time, from 10 to 50 years. A 30-year amortization period is most common.
- Payments are credited first to interest, then to principal.
- During the early years of the loan, much of the monthly payment goes toward interest.
- Toward the end of the loan period, much of the monthly payment goes toward principal.
- Yikes, please realize, though, a $200,000 amortized loan at 6% for 30 years means you will pay $231,676 in interest over the life of the loan.
Fixed-Rate Mortgage Benefits
Borrowers gravitate toward fixed-rate mortgages in-lieu-of adjustable-rate mortgages because they like the security of knowing exactly how much they will pay per month for principal and interest.
- The interest rate is fixed, so if overall interest rates increase, it does not affect the fixed-rate borrower.
- Likewise, if overall interest rates decrease, the borrower’s payment still remains the same unless the borrower chooses to refinance the mortgage into a lower rate.
- A borrower can choose to make a larger monthly payment and direct the additional portion of the payment to be paid toward principal, thereby decreasing the principal balance of the loan faster. Paying half your monthly mortgage every two weeks pays off your mortgage in about 22 years. One extra payment per year reduces the amortization period to about 26 years. But additional principal payments are not required.
Should You Pay Points?
You can buy down your mortgage for the first few years by paying a lump sum to the lender. But unless the seller or somebody else is paying this fee for you, it doesn’t make much sense to buy down your own mortgage. You can sock away the money in your own savings account and use that money every month, on which you earn interest, to help pay your own mortgage payment.
Points will decrease your interest rate. Each point is equal to 1% of your loan. To recover the cost of those points, figure out the monthly savings with the lower interest rate versus the rate without points. Then divide that number into your points to arrive at the number of months it will take you to break even. Everything after that is gravy.
For example, say you are paying 2 points on a $200,000 loan to get an interest rate of 5% with a payment of $1,074. Or you could get that $200,000 loan at an interest rate of 6% without points and pay $1,200 per month. The difference between the two payments is $126.
Two points will cost $4,000. To recoup that investment, $4,000 divided by 126 equals almost 32 months. By your 33rd month, after almost three years of payments, you will begin to profit from paying those points.
Collection for Taxes and Insurance
If you are considering a loan that is higher than 80% of the purchase price of your new home, you will likely be asked to pay monthly property taxes and homeowners insurance to your lender. Your lender, in turn, will pay the tax assessor and your insurance company. In this case, your monthly PITI will change from year to year as annual taxes and insurance go up or down.
- Lenders will also collect a reserve, from 2 to 8 months of taxes and insurance, in advance from you.
- This impound account reserve (sometimes referred to as an escrow account) will increase your closing costs.
- The reserve amount collected depends on the time of year and when your annual tax bill is due.
Even if you are putting down 20% or more of the purchase price, often lenders will charge “1/4 point to rate,” meaning you will pay .25% more in interest NOT to set up an impound account. Personally, I prefer to be responsible for paying my own taxes and insurance.
As a hedge against interest rates falling, lenders who make fixed-rate mortgages will sometimes demand a loan feature known as a prepayment penalty. This means if you pay off the loan within a certain number of years, typically one to five years, you will also pay the lender an additional six months of interest, or more.
FHA loans fell out of grace for a few years, but since have rebounded! It’s an institution that has been around for a long time, since June 27, 1934. The Department of Housing & Urban Development folded the Federal Housing Administration (FHA) under its umbrella in 1965.
FHA loans began to lose favor in the late 1990s, when home values began to inch upwards, surpassing FHA mortgage limits, and sellers balked at FHA’s stringent appraisal guidelines.
How FHA Loans Work
Now, FHA does not make loans or guarantee loans. It insures loans. The insurance removes or minimizes the default risk lenders face when buyers put down less than 20 percent. Without further approval from FHA, its approved lenders are authorized to:
Take loan applications
Process loan applications
Underwrite and close the loan
FHA Mortgage Limits
My parents bought our first home in 1955 for $9,000 with an FHA loan. It’s almost inconceivable to think of a home costing that today. As a result, FHA periodically changes its mortgage limits. As of January 1, 2009, the maximum mortgage limit in high-cost areas is 115% of local median prices, not to exceed $625,500. The maximum conforming loan limit is $417,000 for single-family residences nationwide. Your area could support a lower mortgage limit. Here is how to find your FHA mortgage limit.
FHA Loans Allow a Blemished Credit History
If your credit is less than perfect, FHA might be the loan for you. You may qualify for an FHA loan even though you have had financial problems.
FICO scores can be lower than those for a conventional loan.
Bankruptcy. You can obtain an FHA loan two to three years from the date of your bankruptcy discharge, as long as you’ve maintained good credit since your debts were discharged.
Foreclosure. If you keep your credit in excellent shape since a foreclosure, an FHA loan will be available to you two to three years from the final date of your foreclosure.
FHA Loans Boast Competitive Rates & Terms
Today’s terms are pretty straightforward. In fact, in many markets the rates and terms are better than those for 80% / 20% piggyback loans.
There is little or no adjustment to the interest rate for an FHA loan, as the rates vary within .125 percent of a conventional loan.
Mortgage insurance is funded into the loan, meaning a premium of 1.5% is added to the loan balance instead of being paid out-of-pocket. In addition, a small portion for the mortgage insurance premium is added to the monthly payment, but it is far less than private mortgage insurance premiums.
As of January 1, 2009, Borrowers can finance 96.5% of the purchase price and put down 3.5 percent. In some instances, when combined with other types of loans, the down payment can be zero.
Allowable debt ratios are higher than the debt-ratio limits imposed for conventional loans.
FHA Loans Demand Fewer Repairs
At one point, FHA repair demands were so excessive that sellers would discount the list price to buyers who would agree to obtain conventional loans over FHA loans. Today the FHA repair guidelines appear more reasonable.
Defective roofs that leak still need to be replaced but an older roof does not necessitate replacement if it doesn’t leak.
Windows that stick upon opening or have cracked panes do not require replacement.
FHA appraisals do not take the place of a home inspection, never have. Buyers should still obtain a professional home inspection.
FHA loans are available to anybody but are used most often by first-time home buyers and low- to moderate-income buyers. However, there are no income limit qualifications.
This type of government loan is available to veterans who have served in the U.S. Armed Services and, in certain cases, to spouses of deceased veterans. The requirements vary depending on the year of service and whether the discharge was honorable or dishonorable. The main benefit to a VA loan is the borrower does not need a down payment. The loan is guaranteed by the Department of Veteran Affairs, but funded by a conventional lender.
What is a VA Loan?
A VA loan is perhaps the most powerful and flexible lending option on the market today. Rather than issue loans, the VA instead pledges to repay about a quarter of every loan it guarantees in the unlikely event the borrower defaults.
That guarantee gives VA-approved lenders greater protection when lending to military borrowers and often leads to highly competitive rates and terms for qualified veterans.
What are the Key Benefits of a VA Loan?
Far and away, the most significant benefit of a VA loan is the borrower’s ability to purchase with no money down. Apart from the government’s UDSA’s Rural Development home loan and Fannie Mae’s Home Path, it’s all but impossible to find a lending option today that provides borrowers with 100 percent financing.
VA loans also come with less stringent underwriting standards and requirements than conventional loans. In fact, about 80 percent of VA borrowers could not have qualified for a conventional loan. These loans also come with no private mortgage insurance (PMI), a monthly expense that conventional borrowers are required to pay unless they put down at least 20 percent of the loan amount.
Competitive interest rates that are routinely lower than conventional rates
No prepayment penalties
Sellers can pay up to 6 percent of closing costs and concessions
Higher allowable debt-to-income ratios than for many other loans
Streamlined refinancing loans that require no additional underwriting
Interest-Only Mortgage Types
Calling a mortgage loan type an “interest-only mortgage” is a bit misleading because these loans are not really interest only, meaning the borrower pays only interest on the loan. Interest-only loans contain an option to make an interest-only payment. The option is available only for a certain period of time. However, some junior mortgages are indeed interest only and require a balloon payment, consisting of the original loan balance at maturity.
Interest-only mortgages are loans secured by real estate containing an option to make an interest payment. Newspaper headlines often distort the truth about interest-only mortgages, making them out to be bad or risky loans, which is far from the truth.
What is an Interest-Only Mortgage?
Interest-only payments do not contain principal. Many of the interest-only mortgages available today feature an option for interest-only payments.
Here is an example:
$200,000 loan, bearing interest at 6.5%. Amortized payments for a 30-year loan would be $1,254 per month, containing principal and interest.
An interest only payment is $1,083.
The difference between a P&I payment and an interest payment is a savings of $170 per month.
Common Interest-Only Mortgages
The most popular interest-only mortgages do not allow borrowers to make an interest-only payment forever. Generally, that time period is limited to the first five or ten years of the loan. After that period, the loan is amortized for the remainder of its term. This means the payments move up to an amortized amount but the loan balance is not increased. Two popular mortgages are:
A 30-year loan. The option to make interest-only payments is for the first 60 months. On a $200,000 loan at 6.5%, the borrower has the option to pay $1,083 per month at any time within the first five years. For years 6 through 30, the payment will be $1,264.
A 40-year loan. The option to make interest-only payments is for the first 120 months. On a $200,000 loan at 6.5%, the borrower has the option for the first ten years to pay an interest-only payment in any given month. For years 11 through 40, the payment will be $1,264.
How to Compute an Interest-Only Payment
It’s simple to figure mortgage interest. Take an unpaid loan balance of $200,000 and multiply it by the interest rate. In this case, the rate is 6.5%. That number is $13,000 of interest, which is the annual amount of interest. Divide $13,000 by 12 months, which will equal your monthly interest payment or $1,083.
Who Would Take Out an Interest-Only Mortgage?
Interest-only mortgages are beneficial for first-time home buyers. Many new home owners struggle during the first year of ownership because they are not accustomed to paying mortgage payments, which are generally higher than rental payments.
An interest-only mortgage does not require that the home owner pay an interest-only payment. What it does do is give the borrower the OPTION to pay a lower payment during the early years of the loan. If a home owner faces an unexpected bill — say, the water heater needs to be replaced — that could cost the owner $500 or more. By exercising the option that month to pay a lower payment, that option can help to balance the home owner’s budget.
Buyers whose income fluctuate because of earning commissions, for example, instead of a flat salary, also benefit from an interest-only mortgage option. These borrowers often pay interest-only payments during slim months and pay extra toward the principal when bonuses or commissions are received.
How Much Do Interest-Only Mortgages Cost?
Because lenders rarely do anything for free, the cost for an interest-only mortgage is a bit higher than a conventional loan. For example, if a 30-year fixed-rate mortgage is available at the going rate of 6% interest, an interest-only mortgage might cost an extra 1/2 percent or be set at 6.5%.
A lender might also charge a percentage of a point to make the loan. All lender fees vary, so it pays to shop around.
What are the Risks & Myths Associated with an Interest-Only Mortgage?
The important aspect of an interest-only mortgage is to remember that the loan balance will never increase. Option ARM loans contain a provision for negative amortization. Interest-only mortgages do not.
The risk associated with an interest-only mortgage lies in being forced to sell the property if the property has not appreciated. If a borrower pays only the interest each and every month, at the end of, say, five years, the borrower will owe the original loan balance because it has not been reduced. The loan balance will be the same amount as when the loan was originated.
However, even an amortized payment schedule typically will not pay down enough of a 100% financed loan to cover the costs to sell if the property has not appreciated. A larger down payment at the time of purchase reduces the risk associated with an interest-only mortgage.
If property values fall, however, the equity received in the property at the time of purchase could disappear. But most home owners, regardless of whether a loan is amortized, face that risk in a falling market.
Adjustable-Rate Mortgage Types
Adjustable-rate mortgages (ARMs) come in many flavors, colors and sizes. The interest rate fluctuates. It can move up or down monthly, semi-annually, annually or remain fixed for a period of time before it adjusts.
Many adjustable rate mortgages were sold to unsuspecting consumers with the promise of “Don’t worry about the adjustment; you can just refinance.” Well, for some borrowers, refinancing is not a possibility, especially when prepayment penalties are a feature of the loan and still enforceable after the first rate adjustment. Confused? You’re not alone.
Top Three Types of Adjustable Rate Mortgage Loan Products
5/1 ARM loans
Payments are fixed for five years and adjust for remaining 25 years.
3/1 ARM loans
Payments are fixed for three years and adjust for remaining 27 years.
2/1 ARM loans
Payments are fixed for two years and adjust for remaining 28 years.
First Payment Adjustment
Bear in mind that your intial rate has little to do with rate increases; it’s simply a start rate. It’s not tied to an index. It’s the index plus margin that equals your new payment upon adjustment. When your first adjustment rolls around, many loans allow a higher increase than for subsequent adjustments. Some can jump to the maximum cap rate, which could be as much as another 5 to 6 percent.
Let’s say you borrowed $300,000 at an initial rate of 4% and pay $1,432.25 per month for principal and interest. If your rate moved to 6.5%, your payment would increase to $1,896.20, or about $464 more a month. If your rate moved to 9%, your payment would be $2,413.86, or a difference of an additional $982 a month. Short of taking on a second or third job, few borrowers can afford such drastic jumps in monthly payments.
So what can you do?
Refinance to a Fixed-Rate Mortgage
This option is feasible if you have enough equity and can afford higher payments.
If homes prices fall and appreciation declines, you might not have any equity.
Beware of prepayment penalties; some equal six-months of unearned interest.
Adding refinance costs and points to the loan further reduces equity because your loan balance increases.
Talk to a Reputable Credit Counselor
Arrange to make lower payments, deferring unpaid interest, which will increase your loan balance.
Work out lower payments on other debt obligations to allow for higher mortgage payments, called debt reorganization under bankruptcy laws.
Persuade the lender to come to an agreement on forbearance or postponing your payment increases based on ability to pay at a future date.
Sell Your House
List your house for sale with a real estate agent, providing you have enough equity to pay commissions and costs of sale, typically 7 to 10 percent of sales price.
Sell your house without representation, providing you can afford advertising and marketing expenses, including the advice of a real estate lawyer.
Deed your house to the lender under a deed-in-lieu-of-foreclosure arrangement, accepting that you will receive no money for your equity and a ding on your credit.
Foreclosure, of course, is always an option, but it’s not the most desirable. Especially when there are better alternatives available. The worst thing a home owner can do is nothing.
Hybrid Types of Mortgage Loans
- Option ARM Mortgage Types Option ARM loans are complicated. They are adjustable-rate mortgages, meaning the interest rate fluctuates periodically. Like the name implies, borrowers can choose from a variety of payment options and index rates. But beware of the minimum payment option, which can result in negative amortization.
- Combo / Piggyback Mortgage Loan Types This type of mortgage financing consists of two loans: a first mortgage and a second mortgage. The mortgages can be adjustable-rate mortgages or fixed-rate or a combination of the two. Borrowers take out two loans when the down payment is less than 20% to avoid paying private mortgage insurance.
- Adjustable-Rate Mortgage Types Adjustable-rate mortgages (ARMs) come in many flavors, colors and sizes. The interest rate fluctuates. It can move up or down monthly, semi-annually, annually or remain fixed for a period of time before it adjusts.
- Mortgage Buydowns Borrowers who want to pay a lower interest rate initially often opt for mortgage buydowns. The interest rate is reduced because fees are paid to lower the rate, which is why it’s called a buydown. Buyers, sellers or lenders can buy down the interest rate for the borrower.
Specialty Mortgage Loan Types
- Streamlined-K Mortgage Loans Like the 203K loan program, FHA has another program that provides funds to a borrower to fix-up a home by rolling the funds into one loan. The dollar limits for repair work are lower on a Streamlined-K loan, but it requires less paperwork and is easier to obtain than a 203K.
- Bridge / Swing Loans These types of mortgage loans are used when a seller has put a home on the market — but it has not yet sold — and the seller wants to borrow equity to buy another home. The seller’s existing home is used as security for a bridge (also called swing) loan.
- Equity Mortgage Loan Types Equity loans are second in position and junior to the existing first mortgage. Borrowers take out equity loans to receive cash. The loans can be adjustable, fixed or a line of credit from which the borrower can draw funds as needed.
- Reverse Mortgages Reverse mortgage are available to any person over the age of 62 who has enough equity. Instead of making monthly payments to the lender, the lender makes monthly payments to the borrower for as long as the borrower resides in the home. The interest rate can be fixed or adjustable. Get independent advice from a trusted advisor before taking out a reverse mortgage.