Choosing A Mortgage Plan: What type of mortgage works best for you?
Unless you’re one of the approximately 20% of home buyers who pay cash for their property, you’ll be shopping for a mortgage when buying your new home. It can be…well, confusing. There are a lot of options. Some right for you, some not. To help clear things up, we’ll go through the pros and cons of each of the major mortgage types to help you make a decision or spur further research.
Fixed Rate Loan
This is probably the most popular loan type. And for good reason. With this type of loan, the interest rate and payment remain the same over the duration of the loan. This kind of stability is attractive, and helps the buyer manage their budget since payments will never change month over month. These are typically done as 30-year mortgages. 15-year notes are not uncommon. The shorter term lets you build equity faster, though the high monthly payment that comes with it may be prohibitive. While this type of loan protects you if interest rates rise, conversely it doesn’t benefit you if rates fall. To take advantage of better rates, the borrower has to refinance, which costs money.
Adjustable Rate Mortgages
Sometimes called ARMs, these type of mortgages feature interest rates that adjust after a specified period of time. The most common forms are one year, 3/1, 5/1, 7/1, and 10/1. The first number is the number of years the rate stays constant, and the second number is how frequently the yearly rate resets after that. One of the pluses to this type of loan is that they generally offer a friendlier initial rate than a 30-year fixed loan. The rule of thumb is that the shorter the initial term, the lower the initial rate. The downside, of course, is that after the initial term is over, you’re subject to prevailing market trends, and your rate could skyrocket.
Some buyers like ARMs because it puts more cash in their hands. Instead of paying a higher monthly mortgage, they can use the extra money to put toward other investments. Adjustable rate mortgages are also good for people who know that they will be moving within a certain period of time. Also consider that with lower initial payments, you may be able to afford a more expensive home than you could with a fixed-rate loan.
This type of loan gives you the option of paying interest only for a specified period of time, usually 5 to 10 years, and can be used for both adjustable and fixed-rate mortgages. This type of loan offers a lot of flexibility, and you can pay interest only, or on both interest and principal. In general, this allows you to buy more home because of the lower initial payments. At the end of this initial period, however, your payments will greatly increase. For this reason, most buyers refinance after this initial period ends. The risk here is if your home doesn’t appreciate as expected (hello there housing bubble), which limits your refinancing options. This type of loan is appealing to people who can expect their financial situation to change for the better in the near future. Young professionals, for instance, or older adults who will have children graduating college and thus will have fewer expenses.
A balloon mortgage functions like a typical mortgage – with one important difference. When the life of the loan is over, you must pay off the remaining balance in one lump sum. If you can’t pay off the remainder, you have to refinance at whatever the current marketing conditions dictate. This sounds scary, but this type of loan has some distinct advantages. They usually come with very low interest rates, and thus lower monthly payments. Smart buyers can save in preparation for the final payment and thus their homes are paid off much sooner than a traditional 30-year mortgage. This type of loan is also good for homeowners who know that they will move before they have to come up with the final balloon payment.
Buyers who don’t have a steady income, like a salesperson for example, like this type of loan due to its flexibility. Usually each month the buyer has the option of making a low payment option, an interest-only option, or an interest plus principal option. This type of loan does have some downsides. If you only pay the low payment option, you’ll be negatively amortizing your mortgage, meaning you’ll end up owing more over time. Being upside down like this on your mortgage severely limits your options when it comes time to refinance or sell.
Some other type of loans to consider if you meet certain criteria
An FHA loan is backed by a Federal Housing Administration approved lender. The appeal to this type of loan is that it allows the buyer to put down a very low amount, usually around 3.5 percent of purchase price. This type of loan is designed to help the first-time buyer, people with low incomes, or those with a poor credit rating. The downside is that the amount of the loan is usually limited, meaning the inventory of available homes is also limited.
This type of loan is a great option for military and veterans. Offered by private banks, VA loans are packed with advantages. For one, they are guaranteed against default, meaning that if the buyer can’t repay the loan, lenders are still protected. Another huge plus is that they require little, if any, down payment and still don’t require the buyer pay private mortgage insurance (PMI) that conventional loans would demand with so little down.
The bottom line
There are a lot of options when it comes to financing the purchase of a house. It pays for you to take the time to assess your individual financial outlook, as well as any impending lifestyle changes so that you can make the best choice.