Evaluating Mortgage Types

When choosing a mortgage type, there are two questions to keep in mind...

Finding a mortgage can be a strenuous process. Not only are there hundreds of institutions offering mortgages, it can seem as though there are dozens of different types of mortgages themselves. Different interest rates, different lengths and other features can be confusing.

As you shop your options, keep two thoughts in mind:
  1. How long do you expect to live in the home?
  2. What is your tolerance for monthly payments increasing?
Knowing the answers to these questions makes it easier to see the benefits and drawbacks of each type. Read on for an explanation of the common home loan types. 

Fixed Rate Mortgages
 
As the name implies the interest rate on a fixed rate mortgage is set at the time you take out the mortgage and remains constant over the life of the mortgage. This means your monthly payment also remains constant and predictable, which can be reassuring to many buyers.
 
Each monthly payment is comprised of interest and principal. Early on, most of your payment goes towards interest, and towards the end of the life of the mortgage, most of your payment goes toward principal, so most of the mortgage pay down comes late in the mortgage period.
 
Most institutions offer fixed rate mortgages of 30 years and 15 years. Choosing the term of a fixed rate mortgage is usually a function of what level of monthly payments you can afford and how anxious you are to pay off the entire mortgage.
 
The benefit of a shorter 15-year mortgage is that after 15 years you will have paid off the mortgage loan, and you own your home free and clear. You will also pay less interest over the life of the mortgage. The trade off is that your monthly payments will be higher.

15 Year Mortgage  30 Year Mortgage
Mortgage Amount $100,000 $100.000
Interest Rate 3.75% 4.75%
Monthly Payments $727.22 $521.65
Total monthly payments over
the term of the mortgage
$130,900 $187,791
Total principal paid over the
term of the mortgage
$100,000.00 $100,000.00
Total interest paid over the
term of the mortgage
$30,900 $87,791

Adjustable Rate Mortgages (ARM)
 
With an adjustable rate mortgage, the interest rate and monthly payments can change as interest rates change. The rate is fixed initially and is subject to being reset based on changes in interest rate benchmarks. The big benefit to the borrower is that usually ARMs have interest rates (at least initially) that are lower than the rates on fixed rate mortgages. 
 
Adjustable rate mortgages are attractive because of their lower initial rate. Your risk is that your rate and monthly payment will rise in the future. If you are comfortable that you can accept an increased payment or if you think you will be moving in a relatively short time, the savings with an ARM can be substantial.
There are several features of ARMs that you should keep in mind as you are considering this type of mortgage.
 
  1. Initial rate. Be careful if the initial rate seems real low. It could be a "teaser" rate that only lasts for a short time and then the rate is adjusted upward. At a minimum, ask what the rate would be adjusted to if the initial rate ended today.

  2. Benchmark the ARM is pegged to. ARM rates are usually tied to some "published" index that reflects the general interest rate market. Usually the ARM rate is adjusted to that benchmark plus some level of margin. Ask your mortgage banker how this works and try to get an understanding of how the benchmark rate has changed recently.

  3. The cap. Most ARMs have limits on how much the rate can rise in any one year, and some ARMs have a limit on how high the rate can rise over the life of the mortgage. Understanding how the caps work will give you an idea of what you will be facing if rates rise substantially.

  4. Length of the rate periods. When you look at ARMs, you may find there are terms like 10/1, 7/1, 4/1 and the like. These refer to how long the initial rate lasts and how often the rate is adjusted after that.

Home Loan Types to Watch Out For

 
Negative amortization. Amortization refers to the process of paying down a mortgage. Some lenders offer mortgages with lower monthly payments than what is needed to pay interest and ultimately pay off the mortgage. This means the amount due on your mortgage increases over time. Avoid this type of mortgage.
 
Balloon mortgages. Balloon mortgages are similar to fixed rate mortgages with steady monthly payments using a 15 or 30 year amortization. However, with a balloon, the mortgage comes due before the full 15 or 30-year amortization. Most balloon mortgages are for 3 to 7 years. They usually offer lower interest rates than the traditional 15 or 30 year fixed rate mortgage. But, remember that with a balloon, your mortgage will be due on a given date and you will have to do something.

15 or 30-Year?

Compare the benefits and drawbacks.

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