Types of Mortgages: Which One Is the Right One?
When the homeowner approaches the lender and they begin the process of filling out the mortgage loan application, it is a very good idea to know what types of mortgages are available and the advantages and disadvantages for each of them. This article takes a look at one year adjustable rate mortgages, fixed rate mortgages, 2-step mortgages, 10/1 adjustable rate mortgages, 5/5 and 5/1 adjustable rate mortgages 3/3 and 3/1 adjustable rate mortgages, 5/25 mortgages, and balloon mortgages.
Fixed Rate Mortgages
A mortgage in which the interest rate remains the same throughout the entire life of the loan is a fixed rate mortgage. These loans are the most popular ones, representing over 75% of all home loans. They usually come in terms of 30, 15, or 10 years, with the 30-year option being the most popular. While the 30-year option is the most popular, a 15-year builds equity much faster.
The biggest advantage of having a fixed rate is that the homeowner knows exactly when the interest and principal payments will be for the length of the loan. This allows the homeowner to budget easier because they know that the interest rate will never change for the duration of the loan.
Not only are fixed rate mortgages the most popular of home loans, but they are also the most predictable. The rate that is agreed upon in the beginning is the rate that will be charged for the entire life of the note. The homeowner can budget because the monthly payments remain the same throughout the entire length of the loan. When rates are high and the homeowner acquires a fixed rate mortgage, the homeowner is later able to refinance when the rates go down. If the interest rates go down and the homeowner wants to refinance, the closing costs must be paid in order to do so. Some banks wishing to keep a good customer account may wave closing costs. If a buyer buys when rates are low they keep that rate locked in even if the broader interest rate environment rises. However, homebuyers pay a premium for locking in certainty, as the interest rates of fixed rate loans are usually higher than on adjustable rate home loans.
Adjustable Rate Mortgages
One Year ARMs
A mortgage loan in which the interest rate changes based on a specific schedule after a “fixed period” at the beginning of the loan, is called an adjustable rate mortgage or ARM. This type of loan is considered to be riskier because the payment can change significantly. In exchange for the risk associated with an ARM, the homeowner is rewarded with an interest rate lower than that of a 30 year fixed rate. When the homeowner acquires a one year adjustable rate mortgage, what they have is a 30 year loan in which the rates change every year on the anniversary of the loan.
However, obtaining a one-year adjustable rate mortgage can allow the customer to qualify for a loan amount that is higher and therefore acquire a more valuable home. Many homeowners with extremely large mortgages can get the one year adjustable rate mortgages and refinance them each year. The low rate lets them buy a more expensive home, and they pay a lower mortgage payment so long as interest rates do not rise.
The loan is considered to be rather risky because the payment can change from year to year in significant amounts. Unless the buyer plans to quickly flip the property or has plenty of other assets and is using an interest-only loan as a tax write off, almost anyone taking adjustable rates should try to pay extra in order to build up equity in case the market turns south.
The 10/1 ARM has an initial interest rate that is fixed for the first ten years of the loan. After the 10 years is up, the rate then adjusts each year for the remainder of the loan. The loan has a life of 30 years, so the homeowner will experience the initial stability of a 30 year mortgage at a cost that is lower than a fixed rate mortgage of the same term. However, the ARM may not be the best choice for those planning on owning the same home for over 10 years unless they regularly make extra payments & plan on paying off their loan early.
An adjustable rate mortgage that has the same interest rate for part of the mortgage and a different rate for the rest of the mortgage is called a 2-step mortgage. The interest rate changes or adjusts in accordance to the rates of the current market. The borrower, on the other hand, might have the option of making the choice between a variable interest rate or a fixed interest rate at the adjustment date.
Those borrowers who make the decision to take a two-step mortgage are taking the risk of the interest rate of the mortgage adjusting upward after the expiration of the fixed-interest rate period. Many borrowers who take the two-step mortgage have plans of refinancing or moving out of the home before the period ends.
5/5 and 5/1 ARMs
The 5/5 and the 5/1 adjustable rate mortgages are amongst the other types of ARMs in which the monthly payment and the interest rate does not change for 5 years. The beginning of the 6th year is when every 5 years the interest rate is adjusted. That’s every year for the 5/1 ARM and every 5 years for the 5/5. These particular ARMs are best if the homeowner plans on living in the home for a period greater than 5 years and can accept the changes later on.
The 5/25 mortgage is also called a “30 due in 5” mortgage and is where the monthly payment and interest rate do not change for 5 years. At the beginning of the 6 th year, the interest rate is adjusted in accordance to the current interest rate. This means the payment will not change for the remainder of the loan. This is a good loan if the homeowner can tolerate a single change of payment during the loan period.
3/3 and 3/1 ARMs
Mortgages where the monthly payment and interest rate remains the same for 3 years are called 3/3 and 3/1 ARMs. At the beginning of the 4th year, the interest rate is changed every three years. That is 3 years for the 3/3 ARM and each year for the 3/1 ARM. This is the type of mortgage that is good for those considering an adjustable rate at the three-year mark.
Balloon mortgages last for a much shorter term and work a lot like a fixed-rate mortgage. The monthly payments are lower because of a large balloon payment at the end of the loan. The reason why the payments are lower is because it is primarily interest that is being paid monthly. Balloon mortgages are great for responsible borrowers with the intentions of selling the home before the due date of the balloon payment. However, homeowners can run into big trouble if they cannot afford the balloon payment, especially if they are required to refinance the balloon payment through the lender of the original loan.