Whether you’re purchasing a new home or are refinancing the one you’re in, it’s critical that you understand the different types of loans available. Since most mortgage terms are for 15 or 30 years, the decision you make today will impact your finances over the long term. Though some mortgages are more popular than others, each situation is different so what’s best for you might be very different than what’s best for many other home buyers.
What’s a Fixed-Rate Mortgage?
As the name suggests, a fixed-rate mortgage has an interest rate that does not change over the life of the loan. Fixed-rate mortgages are one of the most popular types of loans available as borrowers know exactly what their payments will be throughout the life of the mortgage. It’s a very good choice for borrowers who are financially stable and who plan to stay in the home for many years. Lenders usually look for borrowers with a good financial history, solid credit score and decent down payment of 20 percent or more, although some lenders allow down payments that are significantly less, especially if you have other assets or plenty of cash in the bank.
The typical term for a fixed-rate mortgage is 30 years, although 15-year fixed-rate mortgages are gaining in popularity. If you took out a $200,000 30-year fixed-rate mortgage with a 4.5 percent interest rate, you would pay $164,813 in interest over the loan’s term. For the same loan over 15 years instead of 30, you would only pay $75,398 in interest for a total savings in interest payments of $89,415.
What’s an Adjustable-Rate Mortage (ARM)?
Adjustable-rate mortgages start have an initial period where the interest rate is fixed, but then it can increase or decrease at periodic intervals depending on the lender’s going rate. Although ARMs cost less money upfront, have less stringent down payment and credit requirements, and the initial interest rate is lower than a fixed-rate mortgage, it’s not the right choice for the average borrower as the monthly payments can increase significantly during the loan’s term. Since the initial fixed-rate period is typically five or seven years, an ARM is a very good choice for borrowers who plan to sell the home and move before there are any adjustments in the interest rate.
An ARM with a fixed-rate period of five years and then interest rate adjustments annually is called a 5/1 ARM. An adjustable-rate mortgage with a fixed-rate period of seven years and then adjustments every six months is called a 7/6 ARM. There are limits to how much your lender can raise the interest rate during each adjustment period and also over the life of the loan, but the impact can still be significant. If you take out a 5/1 ARM for $200,000 at 4.5 percent with a two percent cap for each adjustment and six percent over the life of the loan, your monthly payment can increase from $1,013.37 to $1,264.14 in year six and up to $1,829.49 if you reach the lifetime cap.
What’s a Balloon Mortgage?
Balloon mortgages are very similar to adjustable-rate mortgages in that they have an initial fixed-rate period. They differ in that the entire balance of the loan becomes due at the end of the fixed-rate period. If you plan to own your home for just a few years, you might jump at the chance to pay the very low rates that balloon mortgages offer, but there is a risk involved. Unless you have the cash in the bank to cover the mortgage principal, you’ll have to either sell your home or refinance your loan. If your home doesn’t sell quickly enough or if interest rates have risen since you took out the balloon mortgage, you could put yourself in a tricky financial situation.
Do I Need a Different Type of Mortgage for My High-End Home?
If you’re looking for a home loan of more than $417,000, you may be required by law to take out a jumbo mortgage. In some counties across the country where the average home price is very high, you might not have to take out a jumbo mortgage unless the loan amount exceeds $625,500. Jumbo mortgages only differ from traditional ARMs and fixed-rate mortgages in the loan amount and the criteria required to qualify.
Lenders will often mandate two appraisals on the home instead of one for a jumbo mortgage, and the down payment required can be anywhere from 15 to 30 percent. The sheer amount of the loan makes it a risk for lenders, and they generally only approve them for highly qualified buyers. Don’t be surprised to see them require a credit score of 700 or higher, a debt-to-income ratio of no more than 43 percent and a minimum cash reserve requirement to cover six to 12 months of payments.
Are There Loans Available for Veterans?
If you’ve served in any branch of the military or National Guard or you’re a surviving spouse, you may be eligible for a VA loan. These types of loans require no down payment, offer low interest rates and have less stringent eligibility requirements than conventional loans. Though there is a complex set of guidelines for who is eligible, it’s generally available to active-duty military with at least six months of service, reservists and National Guard members with at least six years of service (or 90 days when the country is at war) and spouses of military members who either died while they were on active duty or due to a disability that was related to their service.
Does the Federal Housing Administration (FHA) Offer Any Loans?
FHA loans are popular with home buyers who do not have the large down payments often required by lenders of conventional loans and who may not meet the financial requirements. You can take out an FHA loan with a down payment of as little as 3.5 percent. Even though the interest rates may be slightly less than conventional mortgages, every FHA loan requires that the borrower pays for mortgage insurance premiums (MIP) throughout the life of the loan. Unlike the private mortgage insurance (PMI) sometimes required by conventional lenders, the only way to stop paying the MIP is to refinance the loan.
2 Point Highlight
Since the initial fixed-rate period is typically five or seven years, an ARM is a very good choice for borrowers who plan to sell the home and move before there are any adjustments in the interest rate.
Fixed-rate mortgages are one of the most popular types of loans available as borrowers know exactly what their payments will be throughout the life of the mortgage.
