Understanding Traditional Mortgage Types
When shopping for a mortgage, consumers have numerous choices. Many lenders now offer specialty mortgages that help make homeownership more affordable but have risks that consumers should fully consider before selecting. But for most consumers, the traditional fixed-rate mortgage and adjustable-rate mortgage (ARM) continue to be excellent options. However, even these traditional financing options require a number of important decisions. Should you get a 15- or 30-year loan? Should you get a fixed-rate mortgage to lock in today’s interest rates for the term of the loan – or take an adjustable-rate loan with a lower current rate and payment, but with the risk of rate and payment increases in the years ahead?
With a fixed-rate mortgage, you are guaranteed the same interest rate over the life of the loan. Your monthly payments never change, and the loan is paid off completely over the term you select. The key decision regarding a fixed-rate mortgage involves how long you have to pay back the loan. The most common options are 15- and 30-year loans, with the 30-year being the most popular. As the following chart illustrates, a shorter 15-year loan comes with both a lower interest rate and higher monthly payments. As a result, you will pay your loan back faster and repay less interest than with the 30-year loan. Rates, and the differences between rates for 15- and 30- year loans, change daily. The following is only an example.
Interest rate 5.5%
Amount financed $200,000
Monthly payment $1,634
Loan balance after 5 years $150,578
Loan balance after 10 years $85,553
Interest rate 6%
Amount financed $200,000
Monthly payment $1,199
Loan balance after 5 years $186,109
Loan balance after 10 years $167,371
The initial interest rate on an adjustable-rate mortgage (ARM) is generally lower than that for a fixed-rate loan. However, with an ARM, the interest rate may increase or decrease in the future, and the size of your payments will go up or down along with the rate.
Most ARMs are "hybrids," meaning that the interest rate is fixed for a certain number of years – after which the rate begins to float. The most common ARMs fix the initial rate for three, five or seven years. ARMs are probably most appropriate for people who have sufficient financial resources to handle potential payment increases or know that they plan to sell their home around the time the loan’s interest rate is set to change.
Homebuyers who choose an ARM usually intend to sell their home or refinance the ARM before the rate adjusts upward. They also may expect income to increase over time. If you are considering this type of loan, you should be confident that you can afford higher payments that will be required after the rate adjusts if you cannot refinance or sell your home.
Even small changes in your interest rate can increase your monthly payment significantly, resulting in "payment shock." Even a change of one or two percentage points in the interest rate can result in a substantial increase in your required monthly mortgage payment. For example, if the interest rate on your mortgage changes from four percent to six percent, your monthly payment could rise by as much as 50% (from $1,000 to $1,500).
ARMs can be complicated, and many specialty ARMs have risky terms that are appropriate for a small group of borrowers only. Be sure to avoid loans with terms that you don’t understand.
Before choosing an ARM, ask your lender these questions. Make sure that you fully understand the lender’s responses and agree to all of the terms before committing to an ARM.
- How long does the initial interest rate apply?
- How frequently can the interest rate change?
- How is the adjusted interest rate determined? (Generally, a specified amount – the "margin" – is added to a current published rate – the "index.")
- How high can the interest rate go?
- Does the loan set a minimum interest rate?
- Are there any limits on how much the interest rate can change each year?
- Do the monthly payments still pay off the loan even if interest rates increase? (With some loans, the amount you still owe – your "loan balance" – can increase rather than decrease each month. This is called negative amortization.)
- What is the maximum monthly payment that you could be required to pay?
Mortgage programs offered by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA) and the Rural Housing Service (RHS) are designed to provide mortgage options for people who might not qualify for conventional loans. Government-insured loans are particularly helpful for consumers with lower incomes and those who may lack the larger down payments required by conventional loans. These loans often offer consumers loans with better terms and can be a safer and more economical alternative to subprime loans.
Lenders view consumers with lower incomes and little or no down payment as a higher risk for default. With government-insured loan programs, the government agency (FHA, VA or RHS) assumes this risk of default by insuring the loan for the lender.
The FHA, VA and RHS do not loan money to consumers and do not set interest rates. Government-insured loans are available from many private lenders including banks, savings & loans and mortgage companies. When shopping for a mortgage ask lenders about these programs. For a list of lenders who offer government-insured loans in your area visit www.fha.gov, www.va.gov, and www.rurdev.usda.gov/rhs/.
Consumers should note that properties purchased under these programs must meet certain minimum standards and possible loan limits.
Special loan programs
Special loan programs exist to help first-time homebuyers. With some of the programs, you may be able to accept a gift from a relative or to borrow a portion of your down payment and closing costs from a local nonprofit organization or government agency. With others, you may be able to get a grant or other funds that you will not have to repay to cover some of the costs. Ask your REALTOR® or lender about whether you qualify for any such programs.
It’s the law
The Equal Credit Opportunity Act prohibits lenders from discriminating against credit applicants in any aspect of a credit transaction on the basis or race, color, religion, nation origin, sex, marital status, age, whether all or part of the applicant’s income comes from public assistance programs or whether the applicant has in good faith exercised a right under the Consumer Credit Protection Act.
The Fair Housing Act prohibits discrimination in residential real estate transactions on the basis of race, color, religion, sex, handicap, familial status or national origin.
Source: The Federal Reserve Board
Who can government-insured loans help?
- First-time homebuyers
- Consumers who lack money for large down payments
- Consumers who want to keep monthly payments as low as possible
- Consumers worried about qualifying for a loan
- Consumers with less than perfect credit
Which government-insured program meets your needs?
- FHA-insured loans offer very low down payments.
- VA-guaranteed mortgages with no down payment are available to qualified veterans. You must have a certificate of eligibility from the Department of Veterans Affairs for a VA loan.
- The guaranteed rural housing program offered by the RHS is for people who meet certain income requirements and wish to buy a home in a rural area. This government-guaranteed loan requires no down payment.