By: Yara Zakharia, Esq.For most Americans, the decision to purchase a home implicates another critical choice- the type of mortgage that could best provide the financing they need. Considering the value of this investment, understanding mortgage types and entering into the mortgage transaction with knowledge of the essentials becomes primordial. The marketplace abounds with numerous types of mortgage loans, making it oftentimes overwhelming for muddled first-time buyers to educate themselves on the spot and simplify their options. To best compare mortgages and secure the loan product that best corresponds to their needs and financial circumstances, prospective homeowners should gain a thorough understanding of the most frequently-encountered real estate mortgages. The suitable mortgage often depends on how much of a monthly payment borrowers can afford and how long they intend to stay in the home. What follows is an explanation of mortgage types that rank among the most popular financing options in the U.S.:
1. Government loans
The three main types of mortgages guaranteed by the federal government are FHA loans, VA loans, and RHS loans. The Federal Housing Administration administers FHA mortgages, which are fixed-rate loans intended for first-time home purchasers in the low to moderate income bracket. Borrowers may utilize an FHA loan to purchase a single or multi-family home, provided they plan to own and occupy it. Compared to other types of mortgages, FHA loans accept a lower down payment- typically around 3 percent. Their eligibility requirements are also more liberal and their interest rate lower than traditional fixed-rate mortgages. FHA loan amounts must comply with statutory limits.
The U.S. Department of Veterans Affairs guarantees VA loans which are available to individuals who have been active in the military or are the spouse of an active military service person. Service members and veterans who can show that they are able to make monthly payments qualify for a small or no down payment as well as favorable mortgage terms. VA loans are easier to qualify for than traditional loans. Lenders usually cap the loan amount to $203,000.
Another government-guaranteed loan is the RHS mortgage, which is guaranteed by the Department of Agriculture's Rural Housing Service. This type of loan is issued to borrowers who are buying a home in a Rural Development-eligible area and who are in the low to moderate income bracket. The RHS loan requires no mortgage insurance or down payment and minimal closing costs. Even prospective homeowners with tarnished credit can utilize this mortgage to finance home purchases.
2. Conventional loans
These include mortgages other than RHS, VA or FHA and may be either conforming or non-conforming. Conforming types of mortgages comply with the guidelines established by Freddie Mac and Fannie Mae, two corporations that buy mortgages, package them into securities, and then sell the latter to investors. These two stockholder-owned entities determine the borrower's income and credit requirements, down payment, maximum loan amount, and qualifying properties. Each year, they set new loan limits.
3. Jumbo loans
These types of mortgage loans exceed the maximum loan limits set by Freddie Mac and Fannie Mae. While jumbo loans are usually characterized by a slightly higher rate of interest than conforming loans, the disparity between the two will vary depending on the economy.
4. B/C loans
These refer to mortgages that, unlike 'A' paper conforming loans, fail to satisfy Fannie Mae and Freddie Mac's applicant credit requirements. B, C, and D paper mortgages are designed for borrowers who face foreclosure, recently filed for bankruptcy, or are delinquent in their payments as reflected in their credit reports. The objective of B/C loans is to provide short-term financing for this category of borrowers and thus enable them to be eligible for 'A' loans.
5. Fixed-rate loans
Almost 70% of residential purchase transactions are financed via these types of mortgages, which boast a steady interest rate and monthly payments throughout the loan's term. At the beginning of the amortization period, a significant portion of the monthly payment is applied to the interest. As the mortgage is paid down, a larger chunk of the monthly payment is allocated to payment of the principal. Fixed-rate mortgages (FRMs) are available for 10, 15, 20, 25, 30, and 40 years, the most common being 15 and 30 years. A shorter loan term translates into a lower interest rate.
Balloon loans are fixed-rate mortgages for a short term- generally 3, 5 or 7 years- and are characterized by stable monthly payments and a lump sum due at the end of the term. The rate of interest on balloon mortgages is almost as low as those found in an ARM and lower than that of a 15 or 30-year mortgage. On the loan's maturity date, the borrower must pay the outstanding principal either through a refinance of his or her home or out of pocket.
6. Adjustable rate mortgage (ARM)
Also known as a variable loan, this mortgage boasts an interest rate and consequently monthly payments that adjust periodically over the term of the loan. Most ARMs begin with a fixed rate for a certain period, typically 3, 5, or 7 years, and then convert to an adjustable rate. The rate of interest of an ARM is pegged to an index and varies in accordance with market rates. Loan payments increase when the prevailing market rate rises and decrease when it falls. Some of the most commonly-utilized ARM indexes are the Treasury Bill, the Prime Rate, LIBOR, COSI, and CODI. The majority of ARMS carry (1) a periodic cap, which sets a ceiling on how much the rate of interest can increase during each adjustment period and (2) a lifetime cap, which limits how much the rate of interest can rise over the term of the loan. ARMS usually offer a lower initial rate of interest than FRMs. One type of ARM is the option ARM mortgage, which enables borrowers to make very low payments for a certain period, after which the monthly payments will increase gradually over time.
7. Hybrid loans
These types of mortgages combine ARM and fixed loan features and are available in different forms including the (1) fixed-period ARM, (2) two-step mortgage, (3) convertible ARM, and (4) graduated payment mortgage (GPM).
8. Interest-only mortgage
With interest-only mortgage loans, homeowners pay solely the interest on the mortgage for a designated period of time. Since the principal is not paid during this introductory period, borrowers will have a smaller monthly payment to make over the short term.
