What You Need To Know About Mortgage Types Before Applying For A Loan
A mortgage is not a “one size fits all” loan. There are several types of mortgages that you as a prospective home buyer can obtain. Some types of mortgages are more specialized than others, meaning that they are offered for specific purposes only or to meet certain requirements of borrowers.
The type of mortgage you choose will depend on several factors such as:
- Amount of money you intend to invest in the property
- The length of time that you expect to live in your home
- The presence of your other financial obligations like loans, auto payments, etc.
- Saving money for future expenses like college education for your children
For example, if you plan to stay in your new home for the long term, you will want to take out a fixed-rate mortgage and make sure it has the lowest interest rate possible. If you have a child who will be going to college or trade school in 5 to 10 years, you may want to choose an adjustable-rate mortgage or a balloon mortgage which will require lower payments in the beginning so money can be devoted to savings for education.
Fixed-rate mortgages are the most preferred option among home buyers. The fixed-rate mortgage is a type of mortgage with an interest rate which which stays the same during the loan repayment term. So the borrower will not have to worry about any surprise increases when the next payment is due. The only variables that are likely be affected by the passage of time are the amount of property tax you will pay as well as insurance premiums that are included in the mortgage payment. For this reason, the fixed-rate mortgage is the best option for many prospective home buyers.
Con and Pros of A 30 and 15 Year Mortgage
Although you can find fixed-rate mortgages with terms ranging from 15 to 40 years depending on the financial institution offering the loan, the most common terms are 15 and 30 years. Depending on the length of mortgage term you chose, the benefits you get will also vary. You should consider all the pros and cons of a 15 and 30-year mortgage in terms of tax-savings, interest payments and other considerations when deciding which one is the best option for you.
30-year fixed-rate mortgage
According to Freddie Mac, a great majority of home buyers choose the conventional 30-year fixed-rate mortgage. It is important to note that homeowners who are paying off a mortgage loan are allowed to deduct the total amount of interest they’ve paid on their loan when they file their income tax return each year. So the primary benefit of a 30-year fixed-rate loan is that you can obtain the maximum amount of interest deduction over the course of the loan. At the same time, the monthly payments will be lower since they are spread over a very long period of time. In return, however, you will end up paying much more interest in total compared to a 15-year fixed-rate mortgage.
A 30-year fixed-rate mortgage may be the perfect option if you intend to stay in your home less than 10 years and you do not foresee any changes in your income. You will not only benefit from the smaller monthly payments but also won’t have to pay as much interest since you’ll be selling your home long before your mortgage’s pay-off date. Typically, a 30-year term is the easiest form of fixed-rate mortgage to qualify for.
15-year fixed-rate mortgage
In recent years, shorter term mortgages have become more popular for several reasons. A 15-year fixed-rate mortgage has several benefits for homeowners. These types of short-term fixed-rate mortgages generally do offer lower interest rates. Another advantage to this length of loan is that you will not only be able to pay off the loan faster and save tens of thousands of dollars in interest but will also accumulate more equity in your home sooner than would have been possible with a 30-year loan.
If you go with a 15-year fixed-rate mortgage, you will receive smaller tax deductions during the year compared to a 30-year fixed-rate mortgage since your total interest payments will be much smaller each year. However, the amount of your monthly payments will be higher than they would be with a 30-year fixed-rate loan since there is less time to spread the costs across. However, keep in mind that a short-term loan may be very risky if your income happens to drop.
You should also consider how long you intend to live in your home. If you plan on living there for 15 or more years, then a 15-year loan may be a much better option as you will be saving a great deal of money off the amount of interest you’ll be paying during the life of a 30-year loan.
An Adjustable-rate mortgage (ARM) is a type of mortgage that has a variable interest rate which is periodically adjusted based on an index such as the Libor rate or Federal Funds rate. This index reflects the cost of borrowing for lenders on credit markets. Initially, adjustable-rate mortgages have a lower interest rate than that of fixed-rate mortgages. Yet, this is no assurance that the rate will stay the same over time. If interest rates rise too much, your monthly payments can skyrocket in just a few years. Adjustable-rate mortgages generally come with a 15 or 30-year term.
For those who expect to live in their homes for several years, the fixed-rate is a more attractive option. However, if the house is a short-term purchase, an adjustable-rate mortgage may be a better choice. You will have to determine this based upon your individual circumstances.
Frequency of Interest Rate Adjustments
With an adjustable-rate mortgage, the frequency of interest rate adjustments will be determined by the terms of your mortgage. Generally, there will be a period of time at the start of your mortgage term where the interest rate will stay the same. As there is no established time period among lenders for the adjustment of the interest rates, your rates could change in as little as one year, or it could take several years.
To give an example of how interest rate adjustments work, let’s say you have a 5/1 year ARM. This means that your mortgage’s interest rate would stay the same for the first five years and then would be adjusted annually according to the terms of your mortgage. If you have a 3/3 year ARM, the beginning interest rate would remain unchanged for the first three years and then it would adjust every three years.
Interest Rate Caps
With adjustable-rate mortgages, there are limits established on how high the interest rates can be increased during the course of the loan. These limits are commonly called interest rate caps. The cap rate also determines how much the interest rate adjustment will be with each occurrence.
Initial cap shows how much the lender can increase the interest rate the first time it adjusts after the fixed-rate period ends. This cap commonly varies between two to five percent. For example, you might have a loan with a two percent initial cap which means that at the first rate change your new interest rate can go up no more than two percentage points higher than the initial rate.
Periodic cap shows how much the lender can increase the interest rate from one adjustment period to the next. This cap is usually two percent. For example, you might have a loan with a two percent initial cap which means that the new rate can’t be more than two percentage points higher than the previous rate.
Lifetime cap shows how much the lender can increase the interest rate in total over the life of the loan. This cap is usually five percent. For example, you might have a loan with a five percent lifetime cap which means that your rate will not increase by more than five percentage points in total than the initial rate over the life of the loan.
The interest rates on adjustable-rate mortgages are often linked to a number of different financial indexes. This could be London Interbank Offered Rate (LIBOR), a one-year U.S. Treasury Bill, Certificate of Deposit (CD) as well as other indexes.
Essentially, mortgage lenders research a particular index to establish the interest rates for adjustable-rate mortgages. Additionally, a margin of two to four percentage points for the lender is added to the chosen interest rate. Since the lender’s interest rate is linked to an index rate, the latter has a direct effect on the former. When the index rate goes up, your mortgage’s interest rate increases as well. Conversely, when the index rate goes down, your interest rate also goes down.
A balloon mortgage is a type of mortgage where its cost (principal and interest) is not fully amortized during the term of the loan. It requires the borrower to make a so-called “balloon payment” or lump-sum payment for the remaining balance at the end of the loan term. These types of mortgages are usually issued for comparatively shorter terms, usually ranging from five to ten years.
Generally, balloon mortgages come with a low, fixed interest rate. A balloon mortgage may be issued as an interest-only loan which allows homeowners to defer paying down the principal for the loan term and to make interest-only payments.
Although balloon mortgages are not as popular as they were before the mortgage crisis of 2008, they can still be appealing to some prospective home buyers as they come with a lower interest rate and smaller monthly payments than conventional mortgages.
Nowadays balloon mortgages are more commonly seen in commercial real estate than in residential real estate. This type of loan is a good option for those who plan to sell the home, pay it off or refinance it prior to the balloon payment becoming due. Nevertheless, getting a balloon mortgage can be a risky approach for most home buyers.
A reverse mortgage or home equity conversion mortgage is a form of loan that is available to senior citizens who have their own home that meets the FHA minimum property standards. A reverse mortgage uses a home’s equity as collateral with no monthly mortgage payments. With this type of loan, the elderly homeowner can convert their current equity in the house into funds that are provided in the form of lump sum cash advances, lines of credit or monthly payments.
In order to qualify for this type of mortgage, borrowers must also meet financial criteria as set by the U.S. Department of Housing and Urban Development (HUD). Also, any existing mortgage on the home must be paid off with the funds from the reverse mortgage loan. A reverse mortgage does not become due as long as you reside in your home, pay property taxes and home insurance and maintain your property according to FHA requirements.
Most of these loans are designed to suit people who have reached retirement age of 62 years or older and have their own home but need some sort of additional income to replace their lost wages. This is an option which is considered by those retirees that do not have substantial savings but need money to pay for their medical bills and living expenses.
Often these funds must be repaid with a certain amount of interest once the home ceases to be the primary residence for more than 12 months. Most of the time, this happens when the borrower dies or sells the home.
State and local government agencies as well as certain mortgage lenders and banks offer some form of reverse mortgage plans. Reverse mortgages carry higher interest rates and associated fees than traditional mortgages. One place to get pertinent facts about reverse mortgages is the AARP website.
Government Backed Mortgages
In an effort to keep the cost of mortgages at reasonable levels and make home ownership more affordable, the government has also intervened to help low-income households secure financing for their first home. As government-backed mortgages protect lenders against defaults on payments, lenders are willing to offer lower interest rates on these loans.
Currently, there are three government agencies that provide support and insurance for mortgages.
- The Federal Housing Administration (FHA)
A division of the U.S. Department of Housing and Urban Development
- The Veterans Administration (VA)
A Federal Agency for veterans
- The Rural Housing Service (RHS)
A branch of the U.S. Department of Agriculture
Obtaining mortgage assistance using any of these agencies requires that lenders must be approved to offer federally insured loans. As a borrower, you will have to use one of the approved lenders. There are also standards that any property must meet in order to qualify for these types of loans.
Federal Housing Administration Loans
The Federal Housing Administration (FHA) provides guaranteed mortgage financing programs for home buyers. The loans are issued by FHA approved lenders rather than the FHA itself. In effect, as the loans are insured by the FHA, they have lower interest rates than comparable conventional loans. This means that more people in low-to-moderate income brackets have the opportunity to buy a home because the loans are made more affordable.
Most FHA loans also require that the down payment for a loan be kept at a minimum level which is typically five percent of the sale price of the home or less. However, there are upper limits on the amount of loan amounts for FHA loans. Generally, these limits will vary by state or region.
With FHA backed loans, you will have a better chance of getting approved for a loan since most lenders are far more likely to deal with potential borrowers who do not meet the standard requirements for conventional mortgages. This provides an excellent opportunity for first-time home buyers or those with bad credit. There are also no restrictions on who can apply for these loans.
Debt to income ratio
One area where FHA insurance makes a big difference is in the area of debt-to-income ratios. The debt to income ratio is defined as the ratio of a person’s total monthly debt obligations to their total monthly income. This ratio helps lenders evaluate the capacity of borrowers to repay their debts. The FHA has different requirements for the debt-to-income ratio than commercial lenders do.
Veterans Administration Loans
The Veterans Administration (VA) loans are not directly offered by the VA itself. Instead, the VA provides guarantees and support for these loans. They are available to veterans of the Armed Forces, active duty military personnel, National Guard, Reserves and unmarried surviving spouses of service members who meet certain requirements.
VA loans are a great alternative as they are more flexible than FHA loans or traditional types of loans. The qualifications for being accepted are far more relaxed, allowing more veterans to have access to the funds to buy a home. The biggest plus is that veterans can obtain a mortgage loan without making a down payment.
Rural Housing Service Loans
Another form of federally backed financing for those who want to buy a new house is the Rural Housing Service (RHS) loan program where the loans are guaranteed by the U.S. Department of Agriculture (USDA). These government funded loans can also be directly acquired through the RHS. The RHS also provides guaranteed loans like the FHA that can be obtained through approved lenders. These low-interest loans require little or no down payment and come with a 30-year fixed-rate.
These loans are designed to encourage rural home ownership in approved rural areas and semi-rural areas across the country. These loans are ideal for low-income families who could not afford to get a mortgage loan through any other means due to their financial constraints.
Other Types Of Mortgages
There are other types of mortgages that are not recognized by some lenders as distinct types or may be limited to certain regions or lenders. Often it comes down to a matter of terminology. One lender identifies a mortgage using one term while another one uses a different term. This often makes researching a particular type of mortgage more complicated.
Rather than spending a lot of time explaining each of these mortgages in detail, it should suffice to briefly list them and give a short description of each type. So if you think some of these mortgage types might meet your individual needs better, you can investigate them further on your own.
When you get a loan to buy a home, it is referred as the first mortgage lien on the property. A second mortgage is a subsequent lien on the property which uses your home as collateral and lets you borrow against your equity in it. A second mortgage usually requires a new appraisal. The funds from a second mortgage are available as a lump sum home equity loan or a home equity line of credit. The money can be used for any purpose such as home repairs and renovation or college education for your children. As second mortgages are riskier for lenders, they usually carry a higher interest rate than first mortgages.
A wraparound mortgage is a form of second mortgage for the purchase of real property. It is used to consolidate the debt of a previous mortgage as well other forms of debt such as debt on another type of loan. The homeowner extends a second mortgage to a prospective buyer to help him purchase the home. This is in addition to any major mortgage that already exist on the property. This type of mortgage allows buyers to obtain financing without having to go through a traditional lender.
A blanket mortgage is a type of loan used to finance the purchase of more than one piece of property. This type of financing can provide an efficient way of getting a single loan for multiple properties. They are mostly popular with home builders and developers as handling multiple mortgages with different interest rates and terms would be very cumbersome. Blanket mortgages allow commercial real estate investors to consolidate numerous loans from different lenders under one financing arrangement. That is, one payment is made to one bank with one set of terms.
A collateral mortgage is a type of loan that is secured against the borrower’s property through a promissory note of indebtedness. This is essentially a form of lien against the property and provides the lender with extra security in case the borrower defaults on the loan. Several lenders will allow you to have your mortgage registered for up to 125% of its value. As the value of your home increases, you can get a home equity line of credit from the lender without the need to refinance your mortgage. In other words, if approved, you can borrow against your home’s equity up to the registered limit without having to re-register your mortgage. By doing so you can avoid the legal and administrative costs associated with it.
A construction mortgage is a short-term, specialized loan which is used to finance the building or renovation of a home or other real estate project. During the construction period, the borrower typically pays only interest on the loan while the funds are released incrementally as construction progresses. As construction loans are deemed to be somewhat risky by lenders, they have higher interest rates compared to conventional loans.
A general mortgage is a type of blanket mortgage that is applied to both the borrower’s present property and any future properties that he or she may purchase using a mortgage loan.
A judicial mortgage refers to a mortgage lien resulting from a judgment passed on a contested case in favor of the creditor to secure a judgment debt. This means that this type of mortgage is established through filing of a judgment with the appointed recorder of mortgages.
A leasehold mortgage refers to a lien placed on the tenant’s interest in the property with the lease transferred to the lender as collateral for a loan to be secured by the tenant. Often a leasehold mortgage is used by a tenant to obtain financing for construction or major renovations to the leased premises. Depending on the length of the lease, interest rates on leasehold mortgages can be higher.
As a side note, it is important to note that when you buy a property, it is classified under one of the two forms of legal ownership: leasehold or freehold. As a freeholder, you own the property and the land it stands on. As a leaseholder, you rent the property from the freeholder for a certain length of time which is usually between 90-120 years.
A legal mortgage is a type of mortgage that secures a specific legal obligation from the debtor based on law. It is the most secure form of security interest, which is basically a legal right granted by a debtor to a lender over the debtor’s property. The terms of this type of mortgage are established by law rather than the individual parties involved. Essentially, a legal mortgage transfers the title to the lender and prevents the borrower from dealing with the mortgaged property while it is subject to the terms of the mortgage.
An open-end mortgage is a type of mortgage that allows the mortgagor to obtain additional funds up to the amount of equity available in the property without refinancing the loan. This type of mortgage gives homeowners the opportunity to use the equity invested in their home to secure a line of credit in the future. This arrangement provides a line of credit rather than a lump-sum loan. As open-ended mortgages are usually offered with an adjustable interest rate, they can be risky for homeowners if the interest rates goes up.
Purchase Money Mortgage
A purchase money mortgage is a type of mortgage issued to the borrower by the seller of a home as part of the deal for the purchase of the property. It can cover a portion of the total cost of the property or a certain portion of it. This type of loan is known as seller financing and used in situations where the buyer have difficulty in qualifying for a mortgage loan through traditional lenders.
Before applying for a mortgage, always consult an experienced loan officer for the best course of action you need to take. A knowledgeable loan officer can examine your finances and needs, and advise you about the type of loan that suits you best.
Keep in mind that when you apply for a mortgage loan, your lender must give you the Closing Disclosure at least three business days before closing on the loan. Closing Disclosure provides the final details about your mortgage such as the terms of the loan, monthly payments and closing costs. During this time, you have the opportunity to carefully examine and cross check the final terms and costs of your mortgage to those in the loan estimate previously provided by the lender.