Understanding Different Types of Loans
Today's homebuyer has many financing options available and while the different choices may seem overwhelming, it is important to have some degree of understanding of the different types.
The best way to find the right mortgage for you is to discuss your finances, your plans, preferences and financial prospects frankly with a mortgage professional.
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There are three major categories of loans: fixed-rate, adjustable-rate and hybrid loans that combine features of both.
Fixed Rate Mortgages
A fixed rate mortgage carries the same interest rate for the life of the loan. These are a popular choice because the fixed monthly payment is easy to plan and budget for.
In the early years the majority of your monthly payment goes to pay the interest. As the principal reduces, less and less of the payment is applied to interest and in the final years the majority of the monthly payment goes to pay off the principal.
Fixed rate mortgages are typically available in 30, 20, 15 or even 10 year terms. There are also "bi-weekly" mortgages, which shorten the loan by calling for half the monthly payment every two weeks. (Since there are 52 weeks in a year, you make 26 payments, or 13 "months" worth, every year.)
Adjustable Rate Mortgages (ARM)
In this type of mortgage the interest rate and monthly payment can change over the life of the loan because the interest rate is tied to an index (such as Treasury Securities) that may rise or fall from time to time. These loans generally begin with an interest rate that is 2-3 percent below a comparable fixed rate mortgage, and could allow you to buy a more expensive home.
ARM loans usually have caps that limit the rate from rising above a certain amount between adjustments (i.e. no more than 2 percent a year) in order to protect against dramatic increases in the rate, as well as a ceiling on how much the rate can go up during the life of the loan (i.e. no more than 6 percent). With these protections and low introductory rates, ARM loans have become the most widely accepted alternative to fixed-rate mortgages.
When interest rates are rising and payment caps go into effect it is possible that the monthly payment is insufficient to cover the interest. In this event the principal is increased to make up for the deficiency, this is referred to as negative amortization.
These combine features of both fixed rate and adjustable rate mortgages. usually a hybrid loan will start with a fixed rate for a certain number of years, and then switch to an adjustable rate. It is important to know how much the rate may increase during the adjustable period, some hybrid loans do not have interest rate caps for the first adjustment period.
Other hybrid loans may start with a fixed interest rate for several years, and then later change to another (usually higher) fixed interest rate for the remainder of the loan term. Lenders frequently charge a lower introductory interest rate for hybrid loans than a fixed rate mortgage which makes hybrid loans attractive to homeowners who desire the stability of a fixed rate, but only plan to stay in their properties for a short time.
A balloon payment refers to a loan that has a large payment due at the end of the loan. For example, there are currently fixed-rate loans which allow homeowners to make payments based on a 30-year loan, even thought the entire balance of the loan may be due (the balloon payment) after 7 years. As with some hybrid loans, balloon loans may be attractive to homeowners who do not plan to stay in their house more than a short period of time.
A conventional loan is simply a loan offered by a traditional private lender. They may be fixed-rate, adjustable, hybrid or other types. While conventional loans may be harder to qualify for than government-backed loans, they often require less paperwork and typically do not have a maximum allowable amount.
FHA and VA loans
U.S. government loan programs such as those of the Federal Housing Authority (FHA) and Department of Veterans Affairs (VA) are designed to promote home ownership for people who are unable to qualify for a conventional loan. Both FHA and VA loans have easier qualifying requirements and generally require low or no down payments.
The loans are made by private lenders but are insured by the U.S. government in case the borrower defaults. VA loans are only available to veterans or their spouses and certain government employees. There is no limit on the size of a VA home loan guarantee but lenders will generally limit to $240,000.
Affordable Housing Programs
A variety of mortgage programs created to help first-time buyers and/or those with low to moderate income. Little or no down payment is required.
Comparing Interest Rates and Fees
Interest rate alone is not a valid basis for comparison between loans because it fails to take into account the other related fees and charges. Lenders are required by the federal government to provide you with the annual percentage rate (APR) in order to help you make comparisons.
APR is the cost of your credit expressed as a yearly rate. It is higher than the note rate because it includes related costs such as points, loan origination fees and other up front charges.
Points are a one time cash payment made up front, this allows the lender to provide a lower interest rate. For this reason a comparison based on interest rates alone can be very misleading.
Try this calculator to compute the monthly payments of a fixed rate loan.
Time is a factor in your loan choice
The length of time you plan to own a property may have a strong influence on the type of loan you choose. For example, if you plan to stay in a home for 10 years or longer, a traditional fixed-rate mortgage may be your best bet. But if you plan on owning a home for a very short period (5 years or less), then the low introductory rate of an adjustable-rate mortgage may make the most financial sense. In general, ARMs have the lowest introductory interest rates, followed by hybrid loans, and then traditional fixed-rate mortgages.