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Mortgage Types Explained
A mortgage is essentially a loan taken out to facilitate the purchase of a home, though the word instills fear and frustration for many consumers because of the various types of home loans available and their differences. Of course, it doesn't help that most Americans will only have one mortgage in their lifetime, while many others will never buy a home. All US mortgages fall into one of two main categories, defined by the interest rate, but are also classified by two other criteria. All mortgages are either fixed-rate mortgages, meaning the interest rate remains the same for the entire life of the loan, or adjustable-rate mortgages, also known as ARMs.
The advantage of a fixed-rate loan is the lack of surprises. A borrower knows what his monthly payments are when it originates. The downside is that if interest rates fall sharply they will be stuck at the higher rate. ARMs, meanwhile, are available with much smaller initial interest rates than fixed-rate products, meaning smaller payments at the beginning of the loan's term. Of course, the interest rate fluctuates with ARMs, so a borrower's payment may rise and fall several times before it's paid off, and so will the payments. Fixed-rate loans usually carry a longer term than ARMs, typically either a 15-, 20-, or 30-year term. ARMs, meanwhile, are usually designed to be paid off more quickly, and are available in terms as short as five or even one year.
In addition to all mortgages being either fixed-rate or adjustable, loans also fall into one of two other categories: conventional or government-insured. Conventional loans are those not insured or guaranteed by a government agency, such as the Federal Housing Administration, or FHA; or the Veterans Administration, or VA. FHA and VA loans allow many people to get loans that would not be able to qualify for a conventional loan, as they are backed by the government, so the lender is protected in case the borrower defaults. FHA loans are available to all buyers, while VA loans can only be secured by active military members, veterans and some spouses. The advantage of insured loans is lower down payments (as low as 3.5% of amount borrowed for FHA loans). The disadvantage, meanwhile, is that FHA borrowers are required to carry mortgage insurance, increasing their monthly payments.
The third distinction for mortgages is related to the amount borrowed. Most home loans are conforming loans, meaning that they conform to maximum size limits defined by Fannie Mae and Freddie Mac, the two government-run corporations that buy and sell mortgage-related securities. Jumbo loans are classified as such because the amount borrowed exceeds these limits, and represent a higher risk to the lender because of the amount. As a result, lenders typically require very high credit scores and down payments for jumbo loan borrowers, and interest rates are usually higher. All home loans are categorized as either conforming or jumbo, conventional or insured, and fixed-rate or adjustable-rate.
Besides the three major distinctions for home loans, there are three other types of mortgage products offered by lenders. A balloon mortgage offers borrowers very small payments for a fixed amount of time, making it a viable option for borrowers that know their income will increase in the coming months. The disadvantage is that the entire balance of the loan is due after the fixed period, meaning great risk to the borrower if anything happens to derail their finances before the loan is paid off. Most balloon mortgages have a fixed interest rate, though some jumbo loans are also structured as balloon loans.
One type of balloon mortgage is an interest-only loan, meaning the borrower pays only the interest for a fixed period. After the fixed period, the borrower is responsible for much bigger monthly payments, or a large balloon payment becomes due. In some cases, the borrower is required to come up with the entire balance of the loan after the interest-only period, meaning any setbacks to the borrower's financial situation could cause them to have to refinance to make the balloon payment or even lose their home.
The final type of mortgage we'll discuss here is a reverse mortgage, and differs from all other loans in that it is not used for home purchases or refinancing. Designed to help elderly homeowners on fixed incomes, a reverse mortgage allows seniors to convert equity they have in their homes to cash. Proceeds from a reverse mortgage can be paid out in one lump sum, over time in payments, or as a line of credit. The borrower is not required to make payments as long as they remain in the home, though the bank gets the house if the borrower dies and their estate is not big enough to pay the balance. The biggest disadvantage to a reverse mortgage is that they are often a tool for predatory lenders. Reverse mortgages should be federally insured to prevent these practices.
While understanding the different types of mortgages available is an important first step for home buyers, it's also important to select a good lender and hire an attorney to go over paperwork before signing an agreement. Different lenders offer different products, interest rates and levels of service, so it's important to conduct interviews with several before making a decision.
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