Mortgage loan types
Most lenders offer several types of mortgages. Most fall under the following options:
Fixed-rate mortgages. Because it offers predictability of monthly payment, the traditional 30-year fixed-rate mortgage is still the industry standard. Your total payments are spread over so many years that your monthly payments are lower than they would be on a short-term loan. The tradeoff, however, is that you will pay thousands of dollars more in interest on a 30-year loan than a shorter-term loan.
Fixed-rate mortgages with 15-year terms have become more popular. They usually offer slightly lower interest rates than 30-year loans, but you must make substantially larger monthly payments.
If you want to make pre-payments on your mortgage, contact your lender to arrange a schedule and make sure that you will not be assessed a penalty. The best way to avoid penalties is to be sure that your mortgage loan contract allows you to make prepayments.
In the early years of either a 15- or 30-year fixed rate loan, you pay mostly interest. By the end of the loan term, however, your loan payments increasingly go towards repaying the loan principal. This is the buildup in homeowners’ equity that occurs as ownership in your home gradually shifts from the lender to you.
Adjustable-rate mortgages. Instead of offering an interest rate fixed for the life of the loan, an adjustable-rate mortgage (ARM) features an interest rate that moves up and down with prevailing rates. Early in the ARM’s loan term, its rates will almost always be less than that of a fixed-rate loan. Because the borrower agrees to accept the risk of changing rates over the life of the loan, he or she is rewarded with a lower initial rate.
ARMs come in many varieties. Some adjust their rates every year, while others alter them every three or five years. Loan rates are tied to a number of interest rate indexes. Banks track on a margin, or spread, of two to four percentage points to the underlying index.
The two most-used index rates used to price ARMs in the U.S. residential mortgage lending market are:
11th District Cost of Funds. This is calculated by the Federal Home Loan Bank of San Francisco.
One-year, constant maturity-adjusted, U.S. Treaury Bill.
Most ARMs offer two built-in caps to protect you from enormous increases in monthly payments. A periodic rate cap limits how much your payment can rise at any one time. For example, your loan agreement might stipulate that your rate cannot go up more than two percentage points a year. A lifetime cap limits how much the rate can rise over the term of the loan. The same loan that limits increases to two percentage points a year may also impose a six percentage-point cap for the duration of the loan. Such caps can also apply to rate decreases. Therefore, the loan rate may not fall more than two percentage points in one year, or six points during its lifetime.
In addition to rate caps, many ARMs feature payment caps , which limit the amount your payment can rise over the life of the loan. There is a danger with payment caps: when your monthly payment does not cover the full principal and interest due, negative amortization occurs. This means your loan principal actually increases, shrinking your equity in your home.
Convertible mortgages. A convertible mortgage is an ARM that can be changed to a fixed-rate mortgage at a specified rate. Your lender may give you one chance, or several, to convert. The conversion feature gives you the opportunity to start with a low adjustable rate, then lock in a low fixed rate if mortgage rates rise.
Balloon mortgages. A balloon mortgage requires a series of equal payments, then a large payment, or balloon, at the end of the loan term. The mortgage term may be from three to 10 years. Usually, balloon mortgages are offered at fixed rates, though some adjustable-rate balloon mortgage loans are also available. The payments on a balloon mortgage generally cover interest only, so you do not build equity in the home over time.