Understanding The Different Types Of Mortgage Loans

By Ronald Kimmons. May 7th 2016

For most people, the purchase of a home constitutes the largest single purchase of their entire lives. It is so large, in fact, that people generally do not have the necessary cash on hand to purchase homes outright. Instead, most people end up borrowing money to purchase a home in the form of a mortgage loan. There are various types of mortgage loans from which home buyers can choose, and they all have their advantages and disadvantages. Because of the long-term financial implications of signing a mortgage loan agreement, prospective homeowners should understand the different types of loans available and investigate multiple loan offers before taking an offer from a lender. Read on to find out about the different types of mortgage loans.

Fixed-Interest Mortgage Loans

The most common type of mortgage loan is a fixed-interest mortgage. In this type of loan arrangement, the borrower agrees to make a monthly payment based on a certain percentage of the principal (total amount borrowed) plus a certain amount in interest. Home buyers tend to prefer this option because the fixed interest payments convey a sense of stability. In other words, they can make financial plans with the understanding that they will always have to pay the same amount of money every month toward the mortgage.

As a rule, home buyers like to go with longer payment schedules because it stretches out the payments in such a way that the monthly payment is lower. However, doing so usually results in the buyer needing to pay more in interest every month – increasing the total amount he or she must pay for the house. Borrowers can usually get fixed-interest mortgages with payment plans that last 10, 15, or 20 years. In fact, some lenders offer fixed-interest mortgages that go for as long as 40 years. However, 30-year fixed-interest mortgages are the most popular choice.

Adjustable-Rate Mortgage Loans

As the name implies, an adjustable-rate mortgage is a mortgage loan that has a fluctuating interest rate. Lenders base this rate on an index – which is an expression of the current cost of borrowing money on the market. Because the interest rate is based on an index, it can jump around from month to month. This presents a significant risk to borrower because a rising interest rate can cause larger monthly mortgage payments. As a way to counteract this risk, most adjustable-rate mortgages also incorporate rate caps which limit how high the interest can go. Lenders provide two different kinds of caps in their adjustable-rate mortgage agreements. The first kind of cap limits the total amount that the interest can go up from one year to the next. The second kind of cap limits the total amount that the interest can go up over the entire life of the loan. (To learn more about adjustable-rate mortgage loans, see The Pros And Cons Of Adjustable Rate Mortgage Loans.)

Hybrid Mortgage Loans

A hybrid mortgage is an adjustable-rate mortgage that begins with an initial period of fixed interest. For example, a lender may offer a mortgage loan in which the borrower pays a fixed interest rate for five years and accepts an adjustable rate after that. Such mortgages are particularly beneficial for borrowers when they provide an initial fixed rate that is lower than the current market rates for mortgage interest.

Interest-Only Mortgage Loans

An interest-only mortgage loan has two separate payment periods, the first covering interest and the second covering principal. For example, a basic interest-only mortgage may require the borrower to spend the first five years paying off adjustable-rate interest and the following 25 years paying off the principal. Such mortgages are advantageous in that the payments made during the initial interest-only period are relatively low. This can be particularly good for people who will most likely see a substantial increase of income in the near future. However, borrowers sometimes choose interest-only mortgages because they cannot afford to get into the home any other way, not knowing how they will make the payments on principal when they start. Such mortgage arrangements are extremely risky, as they often result in the buyer defaulting on the loan as soon as the interest-only period ends. When this happens, if the lender forecloses on the home, the lender does not have to pay any principal back to the borrower because the borrower has not paid any principal: the payments made have only been interest.

Government-Backed Mortgage Loans

In some cases, the United States government helps people to purchase homes by allowing them to get mortgage loans guaranteed by the Federal Housing Administration. To get such a loan, borrowers must go to an FHA-approved lender. The lender will then issue a loan with advantageous terms, giving people with low income levels the ability to qualify for home loans when it would not otherwise be possible. Lenders are able to offer these loans because they are guaranteed by the federal government: if the borrower defaults, the government will pay the balance. This eliminates much of the risk involved with originating the loan. FHA loans come in both fixed- and adjustable-interest options. (For more information on government-backed mortgages, see The Benefits Of FHA Home Mortgage Loans.)

In the process of looking for a home loan, home buyers should take all of their options into account, considering the advantages and disadvantages of each. Since this is such a big decision, the help of a personal financial advisor could be advantageous. Make sure that you do all of your homework before signing any loan documents. It could save you a lot of headache down the road.

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