Getting the Type of Mortgage that Is Best For You
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Getting the Type of Mortgage that Is Best For You

Choosing a mortgage loan should seem like a straightforward process; you borrow money from a lender for a specified amount, for a set period of time, and pay it back. However, getting a loan you feel comfortable with, one that's flexible during good times and bad, can be a challenge.

Mortgage loans basically fall into one of two categories: government or conventional. Government loans are normally insured by the Federal Housing Administration (FHA) or the Veteran's Administration (VA). Some offer lower down payments and most offer favorable terms.

Conventional loans can be either conforming or non-conforming. Conforming loans follow the guidelines set forth by The Federal National Mortgage Administration (Fannie Mae) and The Federal Home Loan Mortgage Corporation (Freddie Mac). These types of loans can be either fixed or adjustable. Each is tied into a specific rate, term and limit which can vary from lender to lender. Non-conforming loans, on the other hand, do not adhere to any strict guidelines.

How do fixed-rate mortgages work?

Fixed-rate mortgages retain the same APR throughout the life of the loan. However, the property tax and homeowner's insurance, if built into the cost of the loan, may change over time. The most popular type of fixed loan is a 30-year term.

For those who prefer a shorter timeframe, a 15-year fixed mortgage may be a better option. While the amount of time it takes to repay is shorter, you can usually secure a better interest rate (.25-.50% lower than a 30-year fixed). Besides a 15- and 30-year term, fixed loans are also available 40- and 20-year terms.

Here are some other benefits and drawbacks that a conforming fixed loan has to offer.

Conforming Fixed Mortgage Loan Types

Types of Mortgages Advantages Disadvantages

15- or 20-Year Fixed

  • Interest rate and payment locked-in for the duration of the term should interest rates rise
  • Shorter amortization period allows for a quicker loan repayment leading to equity build-up
  • If interest rates go down you’re still locked-in to your original rate unless you refinance
  • Higher monthly payments than a longer term loan

30- and 40-Year Fixed

  • Interest rate and payment locked-in for the duration of the term should interest rates rise
  • Lower monthly payments due to a longer amortization period
  • If interest rates go down you’re still locked in to your original rate unless you refinance
  • Slow equity build-up since initial payments are mostly interest

How do adjustable rate mortgages work?

Unlike fixed-rate mortgages, Adjustable Rate Mortgages (ARMs) are based on shorter term securities that fluctuate upward or downward based on today's leading indexes (e.g., Constant Maturity Treasury (CMT), London Interbank Offering Rate (LIBOR), or Treasury Bill). A margin is added on top of the index rate by the lender to calculate the interest rate.

Because ARMs are adjustable, they go up and down at pre-set intervals during the duration of the loan. Some offer a low teaser rate to qualify potential buyers which accelerates to a higher rate thereafter. ARMs can adjust once a year, every month, or three to five years, and are typically amortized over a 30 year period. Some offer a lifetime cap which sets the maximum rate that can be charged during the life of the loan with some states having their own percentage limits.

Here are some of the benefits and drawbacks that an adjustable loan has to offer.

Conforming Adjustable Mortgage Loan Types

Types of Mortgages Advantages Disadvantages

Adjustable Rate Mortgage (ARM)

  • Lower payments can make it more attractive to qualify for a larger home
  • Some loans allow an option to convert to a fixed rate

 

  • Rates can adjust upward each year increasing your monthly payments
  • If even possible to convert to a fixed rate loan, the process may require payment of a conversion fee

Interest-only ARM

  • Affordable monthly payments during the initial interest-only period of the loan
  • Can refinance or pay off the loan after the interest only period
  • Can invest your principal savings into a higher yielding investment
  • Higher monthly principal and interest payments once the interest-only payment period ends
  • May not be disciplined in saving up for the pay-off amount
  • Initial interest payments go toward paying down a debt and not reducing the principal balance

Lower your payment with an Interest-only ARM loan

Another variation of the ARM is the Interest-only adjustable rate mortgage. This loan makes it affordable for borrowers to qualify for a loan by giving them the option to pay only the interest (not the principal) for the first 3-10 years of the loan. Monthly payments are usually more affordable. Afterwards, the interest rate adjusts to a traditional ARM at the current indexed interest rate with new principal and interest payments calculated for the remaining term of the loan.

Example

A 30-year ARM loan of $250,000 at 7.50% APR has interest-only payments for 5 years. The payment during this time would be $1,522 per month. After 5 years, the payment would increase to $1,816 per month.

A comparison of all the different loan types shows the potential cost savings you can achieve during the first five years of an interest-only loan versus other conventional loans.

Monthly Payment Comparison for Different Loan Types
Type of Mortgage
Loan Amount
APR*

 

 

Monthly Payment**
30/5 year Interest-only ARM
$250,000
7.31%
$1,522.00
30 year fixed
$250,000
6.17%
$1,720.35
15 year fixed
$250,000
6.05%
$2,429.02
1 year ARM
$250,000
7.67%
$1,987.85
3/1 ARM
$250,000
7.40%
$1,915.98
5/1 ARM
$250,000
7.21%
$1,894.23

 

 

* APR based on national average and may vary.

** Monthly payment includes principal and interest except Interest-only ARM which is interest-only for the first 5 years then jumps to $1,816.59 for the remaining 25 years (principal and interest included.)

Sub-prime loans

Borrowers who have a low FICO score will usually fall into the less than perfect mortgage category. As a result, they'll qualify for a loan but at a much higher rate. Lenders may apply stiffer pre-payment penalty fees in the form of interest payments to dissuade borrowers from building up any equity in their home. Some lenders may require a " balloon" payment to pay off the remaining balance of the loan after a fixed period of time.

Compare the best mortgage rates.

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Featured - 30 Year Fixed Mortgage Rates 2019

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