Types of Mortgage Loans
All mortgage plans can be divided into categories in two different ways. Firstly, conventional and government loans. Secondly, all the various mortgage programs may be classified as fixed rate loans, adjustable rate loans and their combinations.
Conventional and Government Loans
Any mortgage loan other than an FHA, VA or an RHS loan is conventional one.
The Federal Housing Administration (FHA), which is part of the U.S. Dept. of Housing and Urban Development (HUD), administers various mortgage loan programs. FHA loans have lower down payment requirements and are easier to qualify than conventional loans. FHA loans cannot exceed the statutory limit.
VA loans are guaranteed by U.S. Dept. of Veterans Affairs. The guaranty allows veterans and service persons to obtain home loans with favorable loan terms, usually without a down payment. In addition, it is easier to qualify for a VA loan than a conventional loan. Lenders generally limit the maximum VA loan to $203,000. The U.S. Department of Veterans Affairs does not make loans, it guarantees loans made by lenders. VA determines your eligibility and, if you are qualified, VA will issue you a certificate of eligibility to be used in applying for a VA loan.
RHS Loan Programs
The Rural Housing Service (RHS) of the U.S. Dept. of Agriculture guarantees loans for rural residents with minimal closing costs and no down payment.
Ginnie Mae which is part of HUD guarantees securities backed by pools of mortgage loans insured by these three federal agencies – FHA, or VA, or RHS. Securities are sold through financial institutions that trade government securities.
State and Local Housing Programs
Many states, counties and cities provide low to moderate housing finance programs, down payment assistance programs, or programs tailored specifically for a first time buyer. These programs are typically more lenient on the qualification guidelines and often designed with lower upfront fees. Also, there are often loan assistance programs offered at the local or state level such as MCC (Mortgage Credit Certificate) which allows you a tax credit for part of your interest payment. Most of these programs are fixed rate mortgages and have interest rates lower than the current market.
Conventional loans may be conforming and non-conforming. Conforming loans have terms and conditions that follow the guidelines set forth by Fannie Mae and Freddie Mac. These two stockholder-owned corporations purchase mortgage loans complying with the guidelines from mortgage lending institutions, packages the mortgages into securities and sell the securities to investors. By doing so, Fannie Mae and Freddie Mac, like Ginnie Mae, provide a continuous flow of affordable funds for home financing that results in the availability of mortgage credit for Americans.
Fannie Mae and Freddie Mac guidelines establish the maximum loan amount, borrower credit and income requirements, down payment, and suitable properties. Fannie Mae and Freddie Mac announces new loan limits every year.
Loans above the maximum loan amount established by Fannie Mae and Freddie Mac are known as ‘jumbo’ loans. Because jumbo loans are bought and sold on a much smaller scale, they often have a little higher interest rate than conforming, but the spread between the two varies with the economy.
Loans that do not meet the borrower credit requirements of Fannie Mae and Freddie Mac are called ‘B’, ‘C’ and ‘D’ paper loans vs. ‘A’ paper conforming loans. B/C loans are offered to borrowers that may have recently filed for bankruptcy, foreclosure, or have had late payments on their credit reports. Their purpose is to offer temporary financing to these applicants until they can qualify for conforming “A” financing. The interest rates and programs vary, based upon many factors of the borrower’s financial situation and credit history.
Fixed Rate Mortgages
With fixed rate mortgage (FRM) loan the interest rate and your mortgage monthly payments remain fixed for the period of the loan. Fixed-rate mortgages are available for 40, 30, 25, 20, 15 years and 10 years. Generally, the shorter the term of a loan, the lower the interest rate you could get.
The most popular mortgage terms are 30 and 15 years. With the traditional 30-year fixed rate mortgage your monthly payments are lower than they would be on a shorter term loan. But if you can afford higher monthly payments a 15-year fixed-rate mortgage allows you to repay your loan twice as faster and save more than half the total interest costs of a 30-year loan, as illustrated on our graph:
The payments on fixed rate fully amortizing loans are calculated so that at the end of the term the mortgage loan is paid in full. During the early amortization period, a large percentage of the monthly payment is used for paying the interest. As the loan is paid down, more of the monthly payment is applied to principal, as illustrated on our graph:
With bi-weekly mortgage plan you pay half of the monthly mortgage payment every 2 weeks. It allows you to repay a loan much faster. For example, a 30 year loan can be paid off within 18 to 19 years.
Balloon loans are short-term fixed rate loans that have fixed monthly payments based usually upon a 30-year fully amortizing schedule and a lump sum payment at the end of its term. Usually they have terms of 3, 5, and 7 years.
The advantage of this type of loan is that the interest rate on balloon loans is generally lower than 30- and 15- year mortgages resulting in lower monthly payments. The disadvantage is that at the end of the term you will have to come up with a lump sum to pay off your lender, either through a refinance or from your own savings.
Balloon loans with refinancing option allow borrowers to convert the mortgage at the end of the balloon period to a fixed rate loan — based upon the outstanding principal balance — if certain conditions are met. If you refinance the loan at maturity you need not be requalified, nor the property reapproved. The interest rate on the new loan is a current rate at the time of conversion. There might be a minimal processing fee to obtain the new loan. The most popular terms are 5/25 Balloon, and 7/23 Balloon.
Adjustable Rate Mortgages
Variable or adjustable loan is loan whose interest rate, and accordingly monthly payments, fluctuate over the period of the loan. With this type of mortgage, periodic adjustments based on changes in a defined index are made to the interest rate. The index for your particular loan is established at the time of application.
The margin is fixed percentage points added to the index to compute the interest rate. The result will then be rounded to the nearest one-eighth of a percent.
The margins remain fixed for the term of the loan and are not impacted by the financial markets and movement of interest rates. Lenders use a variety of margins depending upon the loan program and adjustment periods.
Most ARMs have an interest rate caps to protect you from enormous increases in monthly payments. A lifetime cap limits the interest rate increase over the life of the loan. A periodic or adjustment cap limits how much your interest rate can rise at one time.
Your mortgage disclosure will tell you the exact index to be used, whether the weekly or monthly value applies, the lead time for your index, the margin, and any caps.
Negatively amortizing loans
Some types of ARMs (for example, option ARM loans) offer payment caps rather than interest rate caps, which limit the amount the monthly payment can increase. If a loan has payment cap but has no periodic interest rate cap, then the loan may become negatively amortized: if the interest rates rise to the point that the monthly mortgage payment does not cover the interest due, any unpaid interest will get added to the loan balance, so the loan balance increases. However, you always have the option to pay the minimum monthly payment, or the fully amortized amount due.
The advantage of negatively amortizing loans is that you can control cash flow (relatively stable payment), take advantage of low interest rates relative to the market at any given time, and pay back the money borrowed today at a depreciated value years from now (because of natural inflation). This makes such loans a great tool for homeowners as long as you understand the mechanics of what’s going on.
With most ARMs, the interest rate can adjust every month, every three or six months, once a year, every three years, or every five years. The interest rate on negatively amortized loans can adjust monthly. A loan with an adjustment period of 6 months is called a 6-month ARM, with an adjustment period of 1 year is called a 1-year ARM, and so on.
Most ARMs offer an initial lower interest rate than the fully indexed rate (index plus margin) during the initial period of the loan, which could be one month or a year or more. It is also known as teaser rate.
All ARMs are available with 30-year terms and some with 15- or 40-year terms.
Adjustable rate mortgages generally have a lower initial interest rate than fixed rate loans.
Option ARM Loans
One of the most creative products that doesn’t require a set payment each month is the option ARM. After the first payment, you get four payment options to choose from each month: your lender sends you a monthly statement offering a minimum payment (1), interest-only payment (2), 30-year amortized payment (3) or 15-year amortized payment (4).
Combined (Hybrid) Loans
Hybrid loans, a combination of fixed and ARM loans, come in different varieties:
With fixed-period ARMs homeowners can enjoy from three to ten years of fixed payments before the initial interest rate change. At the end of the fixed period, the interest rate will adjust annually. Fixed-period ARMs — 30/3/1, 30/5/1, 30/7/1 and 30/10/1 — are generally tied to the one-year Treasury securities index. ARMs with an initial fixed period beside of lifetime and adjustment caps usually have also first adjustment cap. It limits the interest rate you will pay the first time your rate is adjusted. First adjustment caps vary with type of loan program.
The advantage of these loans is that the interest rate is lower than for a 30-year fixed (the lender is not locked in for as long so their risk is lower and they can charge less) but you still get the advantage of a fixed rate for a period of time.
Two-Step mortgages have a fixed rate for a certain time, most often 5 or 7 years, and then interest rate changes to a current market rate. After that adjustment the mortgage maintains new fixed rate for the remaining 23 or 25 years.
Some ARMs come with option to convert them to a fixed-rate mortgage at designated times (usually during the first five years on the adjustment date), if you see interest rates starting to rise. The new rate is established at the current market rate for fixed-rate mortgages.
The conversion is typically done for a nominal fee and requires almost no paperwork. The disadvantage is that the conversion interest rate is typically a little higher than the market rate at that time.
The other kind of convertible mortgage is a fixed rate loan with rate reduction option. If rates had dropped since the time of closing it allows you, under some prescribed conditions, for a small conversion fee to adjust your mortgage to going market rate. Generally the interest rate or discount points may be a little higher for a convertible loan.
Graduated Payment Mortgages (GPMs)
Graduated payment mortgages have payments that start low and gradually increase at predetermined times. A lower initial payments allow you to qualify for a larger loan amount. The monthly payments will eventually be higher in order to catch up from the lower payments. In fact, your loan will be negatively amortizing during the early years of the loan, then pay off the principal at an accelerated pace through the later years.
Lenders offer different GPM payment plans, which vary in the rate of payment increases and the number of years over which the payments will increase. The greater the rate of increase or the longer the period of increase, the lower the mortgage payments in the early years.
A temporary buydown is the type of loan with an initially discounted interest rate which gradually increases to an agreed-upon fixed rate usually within one to three years. An initially discounted rate allows you to qualify for more house with the same income and gives you the advantage of lower initial monthly payments for the first years of the loan when extra money may be needed for furnishings or home improvements. To reduce your monthly payments during the first few years of a mortgage you make an initial lump sum payment to the lender. If you do not have the cash to pay for the buydown, the lender can pay this fee if you agree on a little higher interest rate.
A very popular buydown is the 2-1 buydown.
3-2-1 and 1-0 buydowns are also available, though less common. Compressed Buydown, works the same way, but with the interest rate changing every six months instead of on a yearly basis.
The lower rate may apply for the full duration of the loan or for just the first few years. A buydown may be used to qualify a borrower who would otherwise not qualify . This is because a buydown results in lower payments which are easier to qualify for.
With a variety of different loan programs available, it is important to choose the type of loan that will best suit your needs.
The right type of mortgage chiefly depends on how long you plan on staying in the house and the amount of monthly payment you can comfortably afford.
If you don’t plan to stay in your house for at least 5 to 7 years, it will be reasonable to consider an Adjustable Rate Mortgage, Balloon Mortgage or Two-Step Mortgage. ARMs traditionally offer lower interest rates during the early years of the loan than fixed-rate loans. A Two-Step Mortgage will give you a lower interest rate than a 30-year mortgage for the first five or seven years. A Balloon Mortgage offers lower interest rates for shorter term financing, usually five or seven years. Because of a lower interest rate it is easy to qualify for these type of mortgages. However don’t accept the ARM unless you can afford the maximum possible monthly payment.