Picking a Mortgage

The choice used to be relatively simple: fixed rate vs. adjustable rate. But there are now hundreds of different kinds of loans available to borrowers. Credit.com’s experts show you the pros and cons of the most common loan types.

The two basic mortgage types

Most types of loans fall into two major categories: fixed or adjustable rate. These two types of loans are very different and each work for very different kinds of borrowers. Here’s a quick summary of the differences:

• Fixed rate mortgages (FRM): Mortgages with an interest rate that remains constant for the entire duration of the loan. FRM’s have longer terms (15-30 years) and higher interest rates than adjustable rate mortgages but are not at risk for changing rates. This kind of loan is best if you can afford a slightly higher mortgage payment, have good credit and want to make sure your interest rate will not rise in the future.
• Adjustable rate mortgage (ARM): Mortgages where the interest rate changes periodically based upon a standard financial index. ARM’s offer lower initial interest rates with the risk of rates increasing in the future. In comparison, a fixed rate mortgage (FRM’s) offers a higher rate that will not change for the length of the loan. ARMs often have caps on how much the interest rate can rise or fall. This kind of loan is best if you want a lower mortgage payment, have some credit issues, or think that interest rates will fall in the future.

Let’s see how these loans perform in a hypothetical situation using our free fixed vs. adjustable rate mortgage calculator. The following rates are based on a mortgage of $100,000 after 10 years:

As you can see, the fixed rate mortgage has higher monthly payments but actually ends up costing less after 10 years. The adjustable rate mortgage starts off with a lower payment but costs more in the long run. ARM’s are usually preferred by borrowers who only plan to stay in their home for a few years for this reason. Create your own FRM vs. ARM chart online here.

The Most Common Mortgage Types

Now that you understand the difference between fixed rate and adjustable rate mortgages, the next step is to compare different types of loans available. Here is some brief information about the most popular loan options:

• 1/1 ARM: An adjustable rate mortgage that has a set initial interest rate for the first year. After that period, the mortgage rate adjusts each year. Each annual rate adjustment is based on (or “indexed to”) another rate, often the yield on a U.S. Treasury note. (Also called a “hybrid mortgage.”)
• 2/28 ARM: An adjustable rate mortgage that has a fixed interest rate for the first 2 years. After that period, the mortgage rate adjusts every 28 months.
• 3/1 ARM: An adjustable rate mortgage that has a fixed interest rate for the first 3 years. After that period, the mortgage rate adjusts each year.
• 5/1 ARM: An adjustable rate mortgage that has a fixed interest rate for the first 5 years. After that period, the mortgage rate adjusts each year.
• 7/1 ARM: An adjustable rate mortgage that has a fixed interest rate for the first 7 years. After that period, the mortgage rate adjusts each year.
• 10/1 ARM: An adjustable rate mortgage that has a fixed initial interest rate for the first 10 years. After that period, the mortgage rate adjusts each year. (Also called a “hybrid mortgage.”)
• 15 year FRM: A fixed rate mortgage with a 15-year repayment term. This loan has a lower monthly payment than a 10 year FRM and allows you to quickly build up equity.
• 20 year FRM: A fixed rate mortgage with a 20-year repayment term. This loan has lower monthly payments than a 10 year FRM. Compared to a 30 year FRM, this loan has higher payments and a lower interest rate.
• 25 year FRM: A fixed rate mortgage with a 25-year repayment term. This loan has slightly higher monthly payments than a 30-year FRM.
• 30 year FRM: A fixed rate mortgage with a 30-year repayment term. This is one of the most popular home loans. With this type of loan, your monthly payments are lower than with a 10-25 year FRM but your interest costs are higher. Plus, this loan gives you the best tax advantage by having the largest interest deduction. A 30-year FRM is best if you plan to have a steady income and stay in your home for a long time.
• 40 year FRM: This fixed rate mortgage has a 40 year repayment term. A 40 year FRM has a slightly higher interest rate and a slightly lower monthly payment than a 30 year FRM. However, you will end up paying a lot more interest than if you had a 30-year mortgage.
• 80-10-10 Loan: A combination of an 80% loan-to-value first mortgage, a 10% home equity loan, and a 10% down payment. The loans can be used to eliminate the need for private mortgage insurance. (See “Piggyback loan.”)
• Convertible ARM: An adjustable rate mortgage that can be converted to a fixed-rate mortgage under specified conditions. This type of loan usually includes a higher rate or more points for the convenience of not having to refinance.
• Graduated payment mortgage: A mortgage where the payments increase each month over a set period of time, usually 5 years. After this period, the last payment is fixed as the monthly payment. This type of loan usually has higher rates and has a rising balance for the first few years. Graduated payment mortgages are available as ARMs or FRMs.
• Interest only mortgage: A mortgage where you only pay interest each month during an introductory period, usually 5-10 years. After this period, you have a set amount of time to pay all the principal and interest. This type of loan is best for people who know that their income will rise in a few years or who believe house prices will increase dramatically.
• Option ARM: This kind of adjustable rate mortgage allows you to choose between four payment options each month. With an option ARM, a lender may give you a choice of a minimum payment, interest only payment, a 30 year amortized payment, or a 15 year amortized payment. Option ARMs are best for people who are very organized and who have fluctuating incomes or work on commission. Be aware that the loan’s interest rates can fluctuate and that these loans are complicated to manage.
• Piggyback loan: A small loan that is used to as a down payment and closed at the same time as the mortgage. It is most common to obtain a piggyback loan for 10% of the home price in order to avoid paying private mortgage insurance. (See also “80/10/10 mortgage.”)
• Reverse mortgage: A mortgage that allows elderly borrowers to access their equity without selling their home. The lender makes payments to the borrower with a reverse mortgage. The loan is repaid from the proceeds of the estate when the borrower moves or passes away.
• Two-step loan: This type of loan is a combination of a FRM and ARM. Usually, these loans come in 5/25 or 7/23 terms. For the first 5 or 7 years of the loan, your payments are fixed. After this period, the rate is adjusted once and the payments remain the same for the remaining 23 or 25 years, respectively. These loans have a lower interest rate than a 30-year FRM.

Government Loans

In addition to all these varieties of loans, there are also loan programs sponsored by the government. These loans are designed to help specific types of borrowers afford a home:

• Federal Housing Administration Loans (FHA): This name is somewhat deceiving because the FHA doesn’t actually grant the loans. Instead, they insure lenders who offer loans to borrowers who might not otherwise qualify for commercial mortgages. FHA loans have relaxed down payment and debt-to-income ratio requirements.
• Rural Housing Service Loans (RHS): Borrowers who live in small towns or rural areas may qualify for a loan through the RHS. These loans offer low interest rates and are intended for low income families.
• Veterans Administration loans (VA): These loans are a lot like FHA loans in that the VA only insures them, instead of granting them. VA loans offer relaxed application standards for qualified veterans.

Whew! We have just outlined 24 different kinds of mortgage options for your consideration. Choosing the right mortgage can definitely be overwhelming! Start small by first deciding if you want a fixed rate or adjustable rate mortgage. Once you have decided between these two, explore other mortgage options that fit your requirements.