Basically, there are two categories of mortgages: the fixed rate and the adjustable rate mortgage (ARM). Within these categories, there are many variations.
The most common home loan is the 30-year fixed rate mortgage. The borrower has 30 years to pay back the mortgage at a fixed interest rate and the payments are the same over the life of the loan.
Borrowers choose fixed rate loans because the mortgage payments are steady and predictable, allowing for easier household budgeting and planning. The payments are the same over the life of the mortgage, regardless of interest rate changes. Initially, both the rate and mortgage payment are higher than those of an adjustable rate mortgage. People who choose a fixed rate mortgage usually are planning to keep their home and mortgage for several years.
This type of mortgage enables you to own your home in half the usual time and because the loan is shorter, you pay substantially less in the total interest over the life of the loan. However, because the term is shorter, the monthly payments are higher than those of a 30 year mortgage. Qualification for this type of loan may be more difficult because the income requirement may be higher.
This is a special kind of fixed rate mortgage that offers relatively low, fixed payments as though it were a standard 30-year fixed rate mortgage. After a few years—usually five to seven years—the mortgage term ends with a single large payment (the “balloon”) for all the remaining principal. Borrowers generally have the option to refinance their balloon mortgage to a fixed rate loan at the end of the term. The balloon is considered a short term loan that offers rates and steady payments that are usually lower than those of conventional fixed rate mortgages. Because the term is quite short, the total interest paid is significantly less than a conventional mortgage if the house is sold before the balloon payment comes due.
People who choose this type of mortgage usually don't plan to stay in the home for very long and expect it to appreciate in value quickly. They expect to sell it before the balloon payment is due, but if they do not sell, they must refinance to pay the balloon. If they do refinance, they take the risk that interest rates may be much higher.
In general, adjustable rate mortgages can offer lower interest rates and mortgage payments at first because the borrower assumes the risk of changes in interest rates. Usually borrowers choose ARMs because the lower initial payment makes the home more affordable at first, but the borrower must be willing to accept the risk of an increased mortgage payment, which can sometimes be significantly higher. After a specified time period, the interest rate and payments on an ARM are adjusted based on changes to a specific interest rate index (such as the U.S. treasury bill rate). There is always a floor cap, payment cap, and life cap on the rate. It's important to understand all the aspects of ARMs before you make your decision.
People who choose an ARM usually are intending to sell or refinance before the rate adjusts upward. They also may expect income to increase over time. These borrowers must be confident they could afford the post-adjustment higher payments if they cannot refinance or sell.
There are two types of hybrid loans: those that begin as a fixed rate loan and convert to an ARM and those that begin as an ARM and convert to a fixed rate.
The first type of hybrid ARM offers the predictability of a fixed-rate mortgage at a lower rate for an initial specified period, such as two, three, five, seven or 10 years. This ARM starts as a fixed rate mortgage, then converts to a one year adjustable ARM at the prevailing interest rate, plus an additional amount or margin. The adjustment from the fixed rate period to the ARM and subsequent adjustments can result in significant mortgage payment increases at each stage. The rate is capped at specified amount, so mortgage payments will stop increasing when the rate cap is reached.
People who choose this type of hybrid ARM usually want a predictable payment for a period of time and plan to refinance or move before the rate adjustment. Borrowers must be confident that if they stay in the home, they can afford higher monthly payments after the fixed rate period ends.
This type of mortgage is a hybrid ARM that offers a fixed rate for a set time and adjusts only once—usually at five or seven years—to the current rate at the time.
A convertible ARM is a hybrid ARM that allows you to start with a lower rate ARM and convert to a 30 year fixed loan at a specified conversion rate. In other words, at a specified time, the rate stops adjusting and remains the same for the rest of the loan. However, if the interest rate is at a higher level when it’s time to convert, you may not want to do it. In that case, the loan would become a regular ARM, which would continue to adjust. Borrowers must be confident that if they stay in the home, they can afford higher monthly payments after the lower-rate period ends. There is usually a fee to be paid when the loan converts, and the rate can be slightly higher than the going rate for fixed-rate loans.
This type of loan offers flexibility and choices but can be costly if the buyer does not fully understand all the options. For a period of years — this period is spelled out in the mortgage — borrowers can choose the type of payment made each month. Typically, there are four options:
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a minimum payment that does not cover interest — this option increases the total loan balance
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an interest-only payment that doesn’t reduce the total loan balance
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a payment of interest and principal that pays off the mortgage in 30 years
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a payment of interest and principal that pays off the mortgage in 15 years
After the option period, mortgage payments increase. In some cases, payments may increase before the option period ends. This happens when borrowers choose to make only the minimum payments that do not cover the interest on the loan; the unpaid interest is added to the balance of the loan so the loan balance actually goes up instead of down; this is known as "negative amortization." When the loan balance reaches a certain specified amount, the payments will go up regardless of when the option period ends. Borrowers then must begin making significantly higher payments to lower the loan balance. Paying only minimum payments can increase the amount that is owed to the point where the borrower owes more than the home is worth.
People who choose a payment-option ARM usually want flexibility in making payments and may have an income that is uneven over the year. Common examples are commissioned salespeople who may receive their income in a few large and unpredictable disbursements over the course of a year, as opposed to a steady monthly or bi-weekly paycheck. These borrowers must have sufficient income to cover adjustments, and they often plan to refinance or move before any uncomfortable adjustment occurs.
