LOAN CLASSIFICATIONS
Fixed Rate Mortgages
Your interest rate and monthly payments are fixed for the loan period. 30 and 15 years are the most popular. With a 30-year fixed rate mortgage your monthly payments are lower than they would be on a shorter term, but if you can afford higher monthly payments, a 15-year fixed-rate mortgage allows you to repay your loan twice as fast and cut your interest costs in half. Payments are amortized, which means a large percentage of the initial monthly payments is used for paying the interest. As the loan is paid down, more of the monthly payment is applied to principal and at the end of the term the loan is paid in full.
Another option is a bi-weekly plan that allows you to pay half of your monthly mortgage payment every 2 weeks, allowing you to repay much faster. Many loan companies will charge a set-up fee for this option, but you can accomplish the same result for free by sending in one extra payment per year (every 2 weeks is 26 payments or 13 monthly payments).
Balloon Loans
Short-term fixed rate loans that have fixed monthly payments usually based on a 30-year amortizing schedule and lump sum payment at the end of the term (usually 3, 5, or 7 years). The advantage is that the interest rate is lower resulting in lower monthly payments, but at the end of the term you will have to come up with a lump sum to pay off your lender.
Balloon loans with a refinancing option allow borrowers to convert the mortgage at the end of the balloon period to a fixed rate loan based on the outstanding principal balance - if certain conditions are met. If you refinance the loan at maturity by exercising this option, you don’t have to get re-qualified, nor does your property need to be re-approved. The interest rate on the new loan is a current rate at the time of conversion, plus a pre-set margin.
*Note: if rates have climbed past a certain point, the conversion option may not be available and you many have to re-qualify. Check with your Loan Specialist for details.
Adjustable Rate Mortgages (ARMs)
The interest rate, and accordingly, monthly payments, fluctuate over the loan period. Periodic adjustments are made to the interest rate based on changes in a defined index. The index is established at the time of your loan application and the margins remain fixed for the loan period. Lenders use various of margins depending upon the loan program and adjustment periods. Most ARMs have interest rate caps to protect you from enormous payment increases.
Negatively amortizing loans
Some ARMs offer payment caps rather than periodic interest rate caps, which can lead to a negatively amortized loan: if the interest rates rise to the point that the monthly mortgage payment does not cover the interest due, any unpaid interest will get added to the loan balance, increasing the loan balance. However, you have the option to pay the minimum monthly payment, or the fully amortized amount. The advantage is that you control cash flow (relatively stable payment), take advantage of low interest rates relative to the market and pay back money borrowed today at a depreciated value years from now (because of inflation).
Combined (Hibrid) Loans
Fixed-period ARMs
Homeowners enjoy 3-10 years of fixed payments before the initial interest rate changes. At the end of the fixed period, the interest rate will adjust annually (generally tied to the one-year Treasury securities index. The advantage is that the interest rate is lower than for a 30-year fixed (the lender is not locked in for as long so their risk is lower) but you still get the advantage of a fixed rate for a period of time.
Two-Step Mortgage
Consists of a fixed rate or balloon for a certain time, usually 5 or 7 years, and then the interest rate changes to a current market rate. The mortgage then keeps the new fixed rate for the remaining 23 or 25 years.
Convertible ARMs
Come with the option to convert to a fixed-rate mortgage at designated times, if you see interest rates starting to rise. The new rate is established at the current market rate for fixed-rate mortgages. The conversion is typically done for a nominal fee and requires almost no paperwork. The disadvantage is that the conversion interest rate is typically a little higher than the market rate at that time.
The other kind of convertible mortgage is a fixed rate loan with a rate reduction option. If rates dropped since the time of closing it allows you, under prescribed conditions, for a small conversion fee to adjust your mortgage to the going market rate. Generally the interest rate or discount points may be a little higher for a convertible loan.
Graduated Payment Mortgages (GPMs)
Graduated payment mortgages have payments that start low and gradually increase at pre-determined times. A lower initial payments allow you to qualify for a larger loan amount. The monthly payments will eventually be higher in order to catch up from the lower payments. In fact, your loan will be negatively amortizing during the early years of the loan, then pay off the principal at an accelerated pace through the later years. Lenders offer different GPM payment plans, which vary in the rate of payment increases and the number of years over which the payments will increase. The greater the rate of increase or the longer the period of increase, the lower the mortgage payments in the early years.
Buydown Mortgage
A temporary buydown is the type of loan with an initially discounted interest rate which gradually increases to an agreed-upon fixed rate usually within one to three years. An initially discounted rate allows you to qualify for more house with the same income and gives you the advantage of lower initial monthly payments for the first years of the loan when extra money may be needed for furnishings or home improvements. To reduce your monthly payments during the first few years of a mortgage you make an initial lump sum payment to the lender. If you do not have the cash to pay for the buydown, the lender can pay this fee if you agree on a little higher interest rate. A Compressed Buydown, works the same way, but with the interest rate changing every six months instead of on a yearly basis The lower rate may apply for the full duration of the loan or for just the first few years. A buydown may be used to qualify a borrower who would otherwise not qualify. This is because a buydown results in lower payments which are easier to qualify for.
SELECTING THE RIGHT LOAN
With a variety of different loan programs available, it is important to choose the type of loan that will best suit your needs. The right type of mortgage chiefly depends on how long you plan on staying in the house and the amount of monthly payment you can comfortably afford.
- If you don't plan to stay in your house for at least 5 to 7 years, it will be reasonable to consider an Adjustable Rate Mortgage, Balloon Mortgage or Two-Step Mortgage.
- ARMs traditionally offer lower interest rates during the early years of the loan vs. fixed-rate loans.
- A Two-Step Mortgage, or Balloon, has a lower interest rate than a 30-year mortgage for the first 5-7 years.
- Don't accept the ARM unless you can afford the maximum possible monthly payment. Generally, you should start to consider 15 or 30 year fixed rate mortgages if you plan to stay in your home for more than 7 years.
*Note: although ARMS generally offer lower rates than fixed-rate options, based on market conditions this may not always be true.
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