Mortgage 101

A Few Different Types of Mortgages

Fixed-RateThis is typically the choice of home buyers who want to know exactly what their payment will be month after month for the life of the loan.
Often, the holders of these mortgages are committing to the possibility of long-term residency. The interest rate and the total monthly principal and interest payment remains the same throughout the life of the loan, which usually is 30 years, but can be 10, 15, 20, or even 40 years.

Adjustable-RateThis mortgage has steadily gained in popularity in recent years. It enables a home buyer to secure a loan at a lower interest rate compared to the going fixed rate. The lower, adjustable rate is typically locked in for the first year, or sometimes just a few months, and then adjusts in subsequent years in relation to some economic index – such as the prime lending rate or interest on one-year Treasury bills.

The rate can go up only a certain amount in any given year, usually 1-2 percent. There is also a lifetime cap on the increase, usually 6 percent. So an adjustable rate mortgage that is secured at 5 percent could climb to as high as 11 percent in three years during a period of rapid inflation and rising interest rates.

The primary customers for such mortgages are home buyers having trouble qualifying for a house at a fixed rate because of lack of income, lack of down payment, or too high an existing debt-to-income ratio. With an adjustable-rate mortgage, such buyers can qualify for a larger loan. If they’re anticipating an increase in income or a lowering of debt that will keep pace with the maximum increase in the rates, it’s a safe move.  Often these buyers end up refinancing at a fixed rate once their income enables them to do so.  An adjustable rate mortgage also is attractive to home buyers who know they’ll be staying in a house for only a few years.

Two-stepThese mortgages could be described as a hybrid of the fixed rate and adjustable rate mortgages.  Typically, such loans provide a fixed rate for the first five or seven years of a 30-year mortgage, then revert to a fixed or adjustable rate (convertible or nonconvertible) for the remaining 25 or 23 years.

The adjustable or fixed rate at the end of the five- or seven-year periods is typically tied to some predetermined index and will also include a margin for the lender.  So the home buyer is accepting the risk of facing potentially higher rates after the first five or seven years. But during the first five or seven years, the interest rate is typically lower than the current 30-year fixed rate and higher than adjustable rates.  So, two-step mortgages enable home buyers to secure a rate that’s lower than the fixed rate, but doesn’t have the risk of the potentially rapid increase that comes with an adjustable rate. These mortgages are especially attractive to home buyers who plan to move within a short time-frame – in this case, five to seven years.

FHA Not so much a mortgage type as it is a mortgage program, Federal Housing Administration loans are backed by the U.S. government. That means the lender is reimbursed by the federal government if the borrower defaults on the loan. The primary benefit of the program is that it enables home buyers to purchase a home with a minimal down payment. Typically, just 5 percent is needed, compared to the 20 percent down payment that’s usually needed to secure conventional financing. Some FHA programs enable certain first-time home buyers in particular income brackets to buy a home with a down payment as small as 3 percent. The size of an FHA loan is limited, based on the average cost of housing within a particular geographic area. So, typically, a borrower using FHA financing in a large metro area where housing prices are steep, can borrow a much larger amount than the home buyer shopping in a rural area with lower housing costs.  While the down payment qualifications are much easier to meet with FHA financing, that doesn’t necessarily translate to a better deal over the life of the loan. Mortgage insurance premiums, required because of the minimal down payment, will make monthly payments higher than conventional loan payments at the same interest rate.

VA Another U.S. government loan program is the Veterans Administration loan, which is primarily designed to enable qualifying veterans of the U.S. military to buy a home with no down payment and minimal closing costs.  Depending on your veteran status, there is an origination fee that will add to the cost of using this financing.  A disabled veteran, for example, may not need to pay any fee at all, while a reservist who hasn’t seen active duty might pay the maximum fee, which today can be as high as 3 percent.