Overview: Mortgage Types and Reviews
Most people are familiar with at least one or two types of mortgage loans. At its most basic, a mortgage is a loan secured by a lien on real property. Typically, a mortgage is used to pay for the purchase of a home since most homebuyers don’t have the cash to pay in full. Some other types of mortgages are used to finance home improvements, pay for college or even make a down payment.
Of course, it’s not really that basic. There are many types of mortgage loans, and each is appropriate in certain circumstances. We will briefly look at all the main different types of mortgage loans found in the United States. By the end of this article, you should be able to name each one and understand when it is appropriate.
Image Source: Types of Mortgage Loans
If you are thinking of buying or refinancing a home, take the time to understand each of the different types of mortgages. Each bank offers different products, and many lenders have special names for their financial offerings. If you don’t understand the differences, you run the risk of taking on a loan that benefits your lender far more than it benefits you.
This list is not meant to be exhaustive, but it covers most of the options encountered by the average homebuyer or homeowner. After studying this list, you should be able to speak to your loan officer as an educated consumer.
Instead of taking the lender’s word at face value, you will be able to figure out what basic types of mortgages are offered and what options are best for you, no matter what fancy names the lender has used.
Different types of mortgage loans have been developed in response to different needs. No single one of the mortgage types is better than another. Credit scores, financial standing, family relationships, business arrangements, and many other factors can impact a borrower’s choice. However, some types of mortgages are more common than others. This list is mostly in alphabetical order, but we will begin with the two types of mortgages most often seen by the average homebuyer.
The Two Types of Mortgages Most Commonly Used By Homebuyers
A fixed-rate mortgage is a home loan with a stated interest rate that stays the same over the life of the loan. No matter what happens to the economy, the interest rate remains stable, and neither the borrower nor the lender can change the interest rate for any reason.
This type of mortgage loan is usually made for a period of 10, 15, 20, 25 or 30 years. Other time periods are available, but in the United States, it is rare to see a mortgage with a term of more than 30 years.
Fixed-rate mortgages do not usually offer the lowest interest rates, although rates may drop slightly as the term of the loan decreases.
If you are planning to remain in your home for at least 10 years, this is one of the safest mortgage types you can choose. However, if you know you will be moving in a few years, you could save a lot of money by choosing an adjustable-rate mortgage instead.
An adjustable-rate mortgage, or ARM, is a type of mortgage where the interest rate changes annually or over some other defined period of time. The rate is usually capped, and, typically, it is tied to a common financial index such as the LIBOR. With this type of mortgage loan, for a fixed amount of time at the beginning of the loan period, the borrower has the option to pay only interest.
You probably heard about adjustable-rate mortgages, or ARMs, during the financial and housing crisis of 2007. Crooked lenders convinced hapless homebuyers to take on outrageous ARMs that started with low payments but became unaffordable after a few years.
ARMs can be risky, but they can offer significant savings for some homeowners, and you will find they are still popular today. The government has made many regulatory changes to this type of mortgage loan, and while caution is still necessary, there is no reason to avoid an ARM.
There are hundreds of different types of ARMs, and it would be impossible to document every single offering. However, we have listed some of the most common types of mortgages here. Most of the ARMs you encounter will be similar to one of the following:
- Convertible ARM: This type of mortgage loan allows the borrower to convert an ARM into a fixed-rate mortgage after a specific period of time has passed. It allows the borrower to save on refinancing costs, but it comes with a higher interest rate than a conventional loan.
- Interest-Only ARM: This is a catch-all term for many different types of mortgage loans, as the majority of ARMs allow for interest-only payments during the initial loan term. The borrower does not need to make any payments towards the loan balance until the initial period is over and the interest rate has adjusted.
- Intermediate ARM: also known as a hybrid ARM, a fixed-period ARM or a multiyear mortgage, this product offers the best features from several different types of mortgage loans. The loan begins with a fixed-rate term of anywhere from three to ten years. The fixed “teaser” rate is set below current market rates, and the shorter the initial term, the lower the initial rate.
After the initial period has passed, the interest rate adjusts to market rates on an annual basis or some other regular interval. Loans with names such as 5/1 ARMs and 3/3 ARMs are usually intermediate ARMs. There is usually a cap on how high the rate can go.
- Option ARM: Also known as a flex pay mortgage or flexible payment loan, this type of mortgage gives the borrower a number of different payment choices each month. The borrower can choose between some or all of the following:
- Payments amortized over fifteen years;
- Payments amortized over thirty years;
- Payments amortized over forty years;
- Interest-only payments; or
- A minimum payment set by the lender.
These types of mortgages are tempting because initial rates may be as low as 1%. However, even more than most adjustable-rate mortgages, the option ARM carries a high risk of unexpectedly large monthly payments. The lender, at any time, can recalculate payments to ensure the loan will be paid off on time without a balloon payment at the end.
- 2-Step: After an initial period of time, usually 5 or 7 years, the interest rate on this type of mortgage adjusts to current market rates. On the date the interest rate adjusts, the borrower makes a choice between several options. Often, the choice is between a fixed rate at the current market interest rates or a variable interest rate for the remainder of the loan term.
- 5/1ARM: The first adjustment of interest rates happens after five years, and then the interest rate changes annually.
- 5/5 ARM: The first adjustment of interest rates happens after five years, and then the interest rate changes every five years.
- 5/6 ARM: The first adjustment of interest rates happens after five years, and then the interest rate changes every six months.
- 5/25 ARM: The first adjustment of interest rates happens after five years. At that point, the interest rate is fixed for 25 years.
- 5/25 Balloon ARM: This type of mortgage is just like the 5/25 ARM. However, if certain pre-established conditions are not met after five years, the borrower will have to pay off the remaining loan balance as a balloon payment, and the 25-year period is cancelled. If the conditions are met, the interest adjusts and the payments are stable for the remainder of the loan term.
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Other Types of Mortgages
Image Source: Other Types of Mortgage Loans
These days, there are hundreds of different loan products. The majority of homebuyers will take on one of the types of mortgage loans listed above, but there are many other options, some of which are beneficial to groups such as retirees, first-time homebuyers or borrowers with poor credit. The types of mortgages listed below are not seen as frequently as fixed-rate mortgages or ARMs, but they are all worth considering.
1031 Exchange: While this isn’t one of the different types of mortgage loans, you’ll often see it mentioned in connection with home buying. A 1031 exchange allows an individual to sell his/her property and immediately reinvest the proceeds into a new property. Capital gains taxes are deferred until the new property is sold.
Alt-A Mortgages: This is a mortgage classification rather than a loan product. If a mortgage is considered to be Alt-A, it lies somewhere between subprime loans for individuals with bad credit and the best types of mortgages available to the most-qualified applicants.
Borrowers who qualify for an Alt-A mortgage typically have a higher loan-to-value or debt-to-income ratio or some problem in documenting income rather than having bad credit. An Alt-A mortgage may be fixed, adjustable or anything in between.
Assumable Mortgage: This type of mortgage is rarely seen outside of FHA and VA loans, but since the housing crisis, it has slowly gained popularity. With this product, a homebuyer takes over the seller’s mortgage, taking on all the terms, including interest rate, repayment period, and principal balance. The buyer makes a down payment equal to the seller’s equity in the property.
A borrower who assumes a mortgage does not need to go through the loan origination process and usually does not need to have an appraisal, but the transaction must still meet the lender’s requirements.
Balloon Mortgage/Balloon Conforming Mortgage: This type of mortgage loan features low payments over the life of the loan, and a large one-time payment is required to pay off the balance at the end of the loan term. The payment may be equal to just a few monthly payments or it could be tens or hundreds of thousands of dollars. Balloon mortgages played a large role in the foreclosure crisis.
Bridge Loans: A bridge loan is a short-term mortgage used to finance the purchase of a new property. It is often made when a borrower buys a new home before finding a buyer for his/her old home or when an individual buys a home before receiving a divorce settlement or bonus. The loans usually have high interest rates and must be paid off within a relatively short period of time.
FHA Loan: The United States Department of Housing and Urban Development, through the Federal Housing Administration (FHA), offers several types of mortgages that are collectively referred to as FHA loans. These loans feature lower down payment requirements and usually have relatively low interest rates. Borrowers pay mortgage insurance premiums which guarantee payment to the lender if the borrower defaults.
First-Time Homebuyer Loan: A first-time homebuyer loan could be any one of a number of different types of mortgage loans. The various loans offer many of the following features:
- Low or no down payment
- Reduced or subsidized interest rates
- Grants to help with down payments, closing costs or interest payments
- Limits on fees charged to the borrower
- An extended period of time before loan repayment begins
Some programs require the borrower to have never owned a home while other programs help any borrower who has not owned a home in a certain number of years. Often, there are restrictions on the price of the home, the neighborhood, and the condition of the property.
Hard Money Loans: Also known as a private mortgage, this is a type of mortgage loan not offered by traditional banks. Instead, the money comes from one or more individuals.
The reasons for avoiding a bank are numerous, but this type of mortgage loan is often made when a borrower has credit issues or when the property will be used as an investment. Terms depend on the lender, but interest rates on hard money loans are often extremely high, as are the origination fees, or “points.”
Home Equity Loan: A home equity loan is a loan for a fixed amount of money secured by a mortgage. These types of mortgages are sometimes used by homebuyers to avoid making a down payment. They can also be used by homeowners to finance home improvements, education expenses or any other large purchase.
Home Equity Lines of Credit: Commonly called a HELOC, this type of mortgage is a loan for an open-ended amount of money (with a fixed upper limit) secured by a mortgage. The borrower will usually be given a credit card or check book, and the loan is treated like a bank account. If the borrower never borrows any cash from the line of credit, he or she will never have to make payments.
Interest-only Home Loans: An interest-only loan is usually an ARM. At the beginning of the loan term and for a fixed period of time, the borrower is only required to make interest payments. At a designated point, usually after five or seven years, the borrower begins to make payments on principal and interest.
Jumbo Mortgage: A jumbo mortgage, also known as a nonconforming loan, is a type of mortgage loan that exceeds maximum amounts established annually by Fannie Mae and Freddie Mac. These are often used to purchase luxury homes, but in some high-priced areas, they may be used to finance middle class properties, too. Underwriting standards are less strict for jumbo loans than for conforming loans, but the requirements are still quite rigorous.
No-Cost Loans: If a borrower takes on a no-cost loan, the lender or mortgage broker pays all of the borrower’s settlement costs and fees. This term does not describe a specific type of mortgage loan. A borrower should look carefully at the loan terms to make sure he/she is getting a good deal; ask yourself why the lender or broker is so eager for you to borrow this money.
Note that a “no-cash loan” is a different product, despite the similar name. With a no-cash loan, the borrower pays fees and closing costs, but some or all of those expenses are rolled into the loan balance.
No Documentation Loans: A “no-doc loan,” sometimes called a low-doc, stated income or no ratio loan, could be a fixed- or an adjustable-rate mortgage. Here, a borrower is not required to provide proof of income. These types of mortgages are rare because they present a high level of risk for the lender. The increased risk leads to a high interest rate, and the underwriting requirements are strict. Most borrowers are better off skipping this mortgage type.
Qualified Mortgage: These mortgages require the lender to determine – before making the loan – whether the borrower will be able to repay. Certain underwriting requirements must be met, and the lender may not offer certain predatory features, such as:
- Negative amortization
- Balloon payments
- Loan terms greater than 30 years
Qualified loans also have certain features that make them more attractive. These may include:
- Limits on debt-to-income ratio
- Limits on points and fees paid at or before closing
- Legal protections for lenders, which makes them more willing to lend money
Reverse Mortgages: A reverse mortgage is sometimes called a home equity conversion mortgage. These mortgage types are only available to homeowners 65 and older, and they provide a stable income to the borrower. Part of the equity in the home is paid to the borrower every month, and the loan is repaid upon the death of the borrower or the sale of the premises.
A reverse mortgage can provide a borrower with some much-needed cash, but it comes at a high price. Often, the borrower’s heirs are unable to pay off the balance, and the home, which may have been in the family for generations, is turned over to the bank. The terms are complex and difficult to understand, and this type of mortgage loan should be considered a last resort.
Second Mortgages: A second mortgage could be one of almost any of the various types of mortgage loans. This term refers to any mortgage or line of credit placed on a home that already has a primary mortgage recorded on the land records. They are often used to finance home improvements, pay off credit card debt or even fund a down payment on a new home.
USDA Mortgage: The United States Department of Agriculture (USDA) offers low-cost, low-interest loan programs similar to those offered by the VA and the FHA. USDA loans are made through a program called the USDA Rural Development Guaranteed Housing Program. Borrowers must meet standard underwriting requirements, must fall within income guidelines, and may only purchase a home located in a designated rural area.
VA Home Loan: The United States Department of Veteran Affairs (VA) guarantees mortgage loans to qualified veterans. Since 1944, more than 20 million veterans have been able to purchase a home through this program. Since these types of mortgage loans are guaranteed, banks may offer benefits such as lower interest rates or low closing costs. The loans may be fixed or variable and offer benefits including:
- No down payment requirements for borrowers with good credit
- No mortgage insurance requirements
- Simplified underwriting requirements
VA loans do have funding fees that must be paid at closing. However, this fee is paid directly to the VA, and it helps fund the program for future veterans.
Conclusion – Different Types of Mortgage Loans for Different Situations
As you can see, there are many different types of mortgages, and each is appropriate in a different set of circumstances. But, while it may seem overwhelming, really only a handful of mortgage types are appropriate for the average homebuyer. A banker or loan officer can guide you to the right choices.When the time comes to choose a loan, review your options carefully. Although the worst practices were outlawed during the housing crisis, there are still plenty of ways for lenders to take advantage of borrowers. But, simply learning the language makes a big difference. Knowing the good and bad points of each of the various types of mortgages shows that you are aware of the risks and helps you ignore marketing in favor of the details.
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