Getting a mortgage may be the biggest purchase most Americans will ever make, but you wouldn’t know that from the time most of us spend shopping for one. According to a recent report by the Consumer Financial Protection Bureau, 47 percent of home buyers don’t compare lenders and 77 percent only apply with a single lender or broker (source). That’s scary. You need to know what types of mortgage loans are available. You need to know which loan types are not good for your situation. This guide explores the common mortgage types and compares them so that you can choose wisely.
Types of Mortgages
There are several types of home loans and mortgages. Each comes with its own advantages and disadvantages, so it is important to understand what the options are before you rush into an agreement with a mortgage lender.
Here are the types of mortgage loans to consider:
Fixed rate loans are perhaps the easiest to understand. With a fixed rate loan, your interest rate stays the same over the course of the entire loan. This means that your principal and interest payments never vary for as long as you have the loan. Common term lengths for fixed interest rate loans are 10, 15, 20, or 30 years.
For example, if you have a $200,000 15-year term loan with a fixed APR of 3.25 percent, your mortgage payment would be $1405.34 for the entire term of your loan. That payment would never vary, and your interest rate would stay exactly the same throughout the life of your loan.
An adjustable rate mortgage or ARM is a mortgage with an adjustable interest rate. Unlike a fixed interest rate – which remains the same for the entire term of the loan – the interest rate on an ARM may increase or decline periodically based on an economic index. An index is a guide that lenders use to measure interest rate changes. Common indexes used by lenders include the activity of one, three, and five-year Treasury securities, but there are many others.
Your ARM’s product name specifies the frequency with which your interest rate changes. For instance, a 7/1 ARM is an adjustable rate mortgage in which you have the same initial rate and payment for 7 years. On the eighth year and once every year thereafter, your interest rate can adjust either up or down, depending on market trends at the time.
Similarly, with a 1/1 ARM, your interest rate stays the same for one year, and then adjusts once a year with market trends. With a 3/3 ARM, your interest rate stays the same for 3 years, and then adjusts every 3 years with market trends (source).
Simply put, the first number in an ARM product title is the number of years your interest rate will remain the same, and the second number refers to the frequency of interest rate adjustments after the initial period.
Interest only loans provide you with the option of only paying interest for a specified term, which is usually either 5 or 10 years. During this time, your principal balance does not change. At the end of the specified period, new, higher payments include both principal and interest.
Balloon mortgages are short-term mortgages that follow an amortization schedule like a long-term mortgage. Balloon terms are typically 3, 5, or 7 years. During the balloon term, you will pay both principle and interest on your loan. At the end of the term, you must pay the balance of your loan in one lump sum. This is usually accomplished through refinancing or converting your balloon loan into a long-term fixed rate loan.
There may be other loan types that are specific to your lender. However, these are the basic types of loans you can find.
Pros and cons of a 30-year fixed mortgage
A 30-year fixed mortgage is a popular choice for many home buyers for several reasons. Perhaps the most obvious advantage of a 30-year fixed rate is payment stability. Since your principal and interest payment remains the same for the entire thirty year period, budgeting is easy. And spreading your payments out over 30 years means that you pay less each month than you would with loans with a shorter term (like 15- or 20-year terms), which is why 85 percent of borrowers choose 30-year fixed rate mortgages (source).
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However, there are some downsides to a 30-year fixed rate.
- You will end up paying substantially more in interest over the course of your loan.
- There is always the chance that interest rates, in general, will drop significantly during any 30 year period. To take advantage of lower interest rates, you would need to refinance your home, which involves the extra effort of applying for a loan again and the additional costs you incur every time you get a mortgage, such as closing costs.
- Another potential problem with choosing a 30-year fixed rate is when you decide not to live in your home for that long. Because of the way your loan amortization works, your monthly payment goes mostly to interest for the first several years of a 30-year term. So, if you plan on moving in the next 10 years or so, a 30-year term loan may not be the smartest choice.
Pros and cons of a 15-year fixed mortgage
The advantage of a 15-year fixed mortgage is the payment stability it affords you. Because your payment does not change for the entire 15 years, you can budget accordingly with confidence. A 15-year fixed rate mortgage allows you to build equity in your home more quickly than you will with a 30-year mortgage. Building equity is a good thing. Having equity in your home gives you more refinancing options. Building equity also enables you to obtain a home equity line of credit if needed in the future. In addition, you will end up paying much less in interest over the course of a 15-year term than you would with a 30-year term.
However, there are some drawbacks to a 15-year fixed mortgage.
- The monthly payments may be significantly higher than with a 30-year loan option. For instance, a $200,000 mortgage at 3.25 percent for a 15-year term costs $1405.34 each month. On the other hand, stretching that term out to 30 years means you would only pay $870.41 each month. If your concern is with keeping your payments down on a monthly basis, a 15-year term is not the best choice for you.
- Locking a rate in for 15 years may mean that you will need to refinance later if interest rates drop considerably, which costs money and takes effort.
ARMs vs. Fixed Rate Loans
ARMs typically have a lower initial interest rate than fixed rate mortgages. This means that you may be able to afford a more expensive home with an ARM than you would with a fixed rate loan. An advantage is that interest rates may drop. With an ARM, you do not have to refinance to take advantage of lower interest rates, potentially saving you thousands of dollars.
Also, if you are planning to sell your home in a specified amount of time, an ARM may make sense. For instance, suppose you plan to sell your home in the next five years. Choosing a 5/1 ARM would mean that you lock in your low initial interest rate for the five years you plan to own your home. If you sell your home before the five years is up, you can take advantage of the initial low rate without ever having to pay a higher rate at all.
Even if you don’t plan to sell your home any time soon, an ARM may be a good option depending on how low the initial rate is in comparison to a fixed rate loan.
When an Interest Only Loan makes sense
With an interest only loan, you have the option of only paying interest for a specified time period, or you can choose to pay both principal and interest at your discretion. The advantage to this is that, for the initial specified time period, your payments are quite low. This may make it possible for you to purchase a more expensive home than you could otherwise afford.
Interest only loans make sense if you anticipate having a lot more income in the future than you currently have. For instance, young professionals who are currently paying off student loan debt but anticipate much larger future earnings may find it useful to have an interest only loan. Why? Because once the student loan is paid and the young professional is bringing home more money, a larger mortgage payment is not typically a hardship.
Investors also often choose interest only loans, planning on using the money they save with an interest only loan for investments. If the investments pay off, then an interest only loan might make sense.
If you don’t anticipate making more money in the future, an interest only loan may not be the best option for you. It’s wise to take into account the fact that, at the end of the specified interest-only payment period, you will be responsible for paying both principal and interest for the duration of the loan term and the monthly payment will be considerably higher than the initial payment.
The Risks of Balloon Loans
Balloon loans often provide a lower interest rate than other loan types. However, there are some risks of balloon loans you need to know.
Balloon loans are a good idea if:
- You know you will sell your home before the large lump sum payment is due.
- You are certain that you will be able to refinance your mortgage for a more favorable rate before the lump sum payment is due.
But, here’s the risk. You cannot always depend on being able to sell your home before that big payment is due. And if you have to refinance your home when the large payment is due, there is no guarantee that you will find a good rate or good terms for a refinance.
If that happens, then you are stuck with a higher interest on a refinanced loan and larger payments too. That is bad news.
How to Choose the Right Loan for Your Situation
As you can see, there are a number of factors to consider when choosing a mortgage loan. You must think about your current financial situation, your future earning potential, and your long-range goals pertaining to owning a home.
A good mortgage company can help you sift through the different loan options available to you. Your mortgage lender will sit down and talk with you about your financial situation. He or she will ask questions such as how long you intend to live in the home you’re purchasing, what kind of down payment you can afford to make, and what monthly payment amount you can afford in your budget.
Then, your mortgage company professional will explain your loan options clearly so that you can make a wise choice for your loan. If you are ready to start your search for the right loan today, you can find the best mortgage companies here.