Types of Mortgages
You may think that all mortgages are alike, but they actually come in many shapes and sizes. There are several different terms (15-year, 20-year, or 30-year), fixed interest rate and variable interest rate, balloon mortgages, government-backed mortgages, and more. To choose the best one for your personal situation, you should be familiar with at least these basic types.
Mortgage Terms
Most mortgages are for 15, 20, or 30 years with an interest rate that’s fixed over the life of the loan. Payments on 15- and 20-year loans are somewhat higher than those on traditional 30-year loans, so it requires higher income to qualify for the shorter terms. The benefit is that you build equity faster, pay off your mortgage years sooner, and save many tens of thousands of dollars.
Should I choose a shorter or longer mortgage term?
If you can swing the payments comfortably, the shorter terms are definitely worthwhile. If you’re a disciplined saver, you may be able to do just as well with a 30-year loan if you invest the monthly savings in stocks or mutual funds.
To illustrate the difference between a 30-year and a 15-year mortgage, take the example of a mortgage for $150,000 at 6 percent. The payment on a 15-year loan would be $1,266 per month, and the total interest paid over the life of the loan would be $77,841. The payment on a 30-year mortgage for the same amount at the same interest rate would be $899 per month (a decrease of $367) and the total interest paid over the life of the loan would be $173,757 (an increase of $95,916).
Moreover, interest rates on shorter-term mortgages are generally lower than those on longer-term mortgages, so the difference between the two loans in the example would actually be even greater.
Adjustable-Rate Mortgages
The interest rates on adjustable-rate mortgages (ARMs) vary. They often start out as much as 1.5 to 2 percentage points lower than the prevailing market rates and increase or decrease at predetermined intervals. The amount of increase or decrease depends on whether they’re tied to Treasury bills, CD rates, or some other financial index. The rate is fixed for a certain period (between six months and five years) and then adjusted periodically, perhaps every year or two. The amount the rate can increase at each interval is usually 2 percentage points, and there’s often a lifetime cap of 6 percentage points.
In a time of rising interest rates, it can be disturbing to know that your rate can increase every year. Before taking out an ARM, be sure that you can afford the highest payment possible under the terms of the loan. ARMs might be a good option if you know you’ll only be in the house for a few years, but if you use one because you can’t qualify for a conventional mortgage, you’re risking the possible loss of your house.
Balloon Mortgages
Balloon mortgages have lower interest rates than traditional mortgages, but the loan term is only for five to seven years. At the end of that time, the entire balance is due, and you have to either pay it off or refinance at the rates that are in effect then. If you plan to sell your house, pay it off, or refinance it within the time frame of the loan, this might be an option for you.
Interest-Only Mortgages
If you want a lower payment, you might look toward interest-only mortgage options. With a traditional mortgage, your monthly payment consists of interest and principal. It is designed so that you’ll pay off the entire loan at the end of the loan term (30 years, for example). By eliminating the principal portion of your payment, you spend less each month.
Of course, you never pay down any of your loan with an interest-only mortgage. You’ll owe just as much after 10 years as you did on the day you bought your house. In other words, you don’t build any equity with each monthly mortgage payment — you just service the loan.
This type of loan option allows a borrower to pay only the interest on the mortgage in monthly payments for a fixed number of years, usually five to seven. After that point, the buyer has the option to refinance, pay off the higher balance or face what could be a significantly higher monthly payment. These loans are a good idea for people who want to use such loans strategically, for example, for people expecting a windfall that can wipe out their debt at the end of the term or at least will be earning enough to make the new payments painless.
Negative Amortization Loans
Some loans allow you to pay even less than the monthly interest. These allow you to enjoy a lower monthly payment, but they are extremely risky. A loan with negative amortization actually sets payments at a level that fails to cover the principal and interest due — or creates an option where a borrower can pay less than the principal and interest due whenever they feel like it — which makes the total loan balance rise instead of fall.
With so much risk, what’s the attraction? Negative amortization loans have a significantly lower monthly payment at the start (maybe the first year or two) as compared to more conventional loans.
Unfortunately, the day will come when you have to settle up — usually with dramatically higher monthly payments. People often don’t understand the risks of putting nothing or very little down in exchange for the freedom of paying less than their interest costs on a month-to-month basis. What a shock it then becomes to look at a mortgage statement to find out that six months, a year, or two years in, that you owe more than you originally borrowed!
There are two scenarios where negative amortization can make sense. The first scenario involves experienced real estate investors who understand their particular markets and properties so well that they can take on the risk of such loans because they know they’ll be able to unload their investment on a specific timetable. The second involves individuals with a similarly superior knowledge of the market and solid finances who know they won’t have any trouble selling or refinancing into a more stable loan product later.
The more you borrow relative to the price of the home, the higher the interest rate, so when you make a small down payment, don’t expect to get the best rates. Lenders charge higher rates because there’s more risk that you’ll default if you have little equity in your home.
Government-Backed Mortgages
Government loans such as FHA and VA loans make home ownership possible for people who might not otherwise qualify for a mortgage. The federal government insures the loan, which is issued by a regular lender.
FHA loans allow a smaller down payment than regular mortgages (3 percent rather than 10 or 20 percent), allow a higher debt percentage, and allow you to borrow the down payment and closing costs from a family member, which you can’t do legally with a regular mortgage. VA loans are for veterans and don’t require any down payment. They have even less stringent requirements on the income-to-debt ratio than FHA loans.
Even though they’re insured by the government, FHA and VA loans are not always your best bet. If you have good credit, you should take a look at conventional loans from a bank or mortgage broker for comparison.
If you’re getting ready to purchase or sell a property in South Florida please call Shaun Clarke at 954-895-7123 or email me at shaunclarke@keyes.com