Types of Mortgages
There are two types of mortgages, government and conventional. Learn about fixed rate mortgages vs. adjustable rate mortgages, prepayment penalties and private mortgage insurance.
Two Categories of Mortgages
- Governmental loans are mortgage programs sponsored by a government agency. These include the Federal Housing Administration (FHA), the Veteran’s Administration (VA) for veterans, and the Rural Housing Service (RHS) or Farmers Home Administration (FmHA) for those living in rural areas. These loans work best for homebuyers with low or moderate incomes, because they require low down payments and have less stringent qualifying guidelines. None of these agencies actually loan you the money; they only guarantee loans granted by lenders who participate in the program.
- Conventional loans are loans that are not guaranteed by the government.
Various Types of Mortgages
1. A Fixed Rate Mortgage (FRM) is a mortgage with an unchanging interest rate. This is a lovely option for people who think they'll own their homes for a long period of time, or those don't like change and who prefer an unvarying monthly payment. Lenders charge higher interest rates for these loans because the money is loaned for a longer time and is more of a risk to the lender.
2. Adjustable Rate Mortgage (ARM) is the opposite of a fixed rate mortgage. An ARM has an adjustable interest interest rate that changes over the life of the loan. The benefit -- ARMs usually offer a "teaser" interest rate that is exceptionally low for the first year or so of the loan, and even after that ARM rates are typically lower than those on fixed mortgages. Why? Because ARMs are "capped," often at around 2 percent per year and 6 percent over the course of the loan. Still, ARMs can be risky -- especially when you look at how high interest rates can go (topping 18% in the 1980s). If you get a 30-year fixed rate mortgage at, say, 5 percent interest, it stays at 5 percent for 30 years. If you get a 15-year ARM at 4 percent and interest rates jump to 12 percent a few years later, you'll be paying 3 percent more in interest, even with a cap of, say, 4 percent.
3. Jumbo Loans are loans that exceed conforming loan amounts specified by Fannie Mae and Freddie Mac. Currently, jumbo loans on single-family homes exceed $417,000 ($625,500 in Alaska and Hawaii). Interest rates are generally higher on jumbo loans due to the larger risk of default involved.
Some lenders offer alternative financing for buyers with weak credit histories, previous bankruptcy, or unique financial situations. For instance, No Documentation Loans, are designed for homebuyers who are self-employed, work off commission, or have sources of income that are difficult to document.
Other Things to Know About Mortgages
The only two words that strike more fear into the heart of homeowners than "termite infestation" are our next vocabulary words: prepayment penalty. These penalties for paying off a loan early can be as high as the equivalent of six months' interest on your entire mortgage! It's best to avoid loan offers that include pre-payment penalties when dancing around for mortgages. If that's not possible, negotiate with your broker or lender. Perhaps you can prepay up to 20 percent of the total loan without paying a penalty, or maybe you can arrange to prepay a certain amount annually without penalty.
Private Mortgage Insurance (PMI) is insurance lenders require when a buyer can't pay at least 20 percent of the cost of a home upfront, in the form of a down payment. Why do lenders want 20 percent down? As proof of your financial stability. For buyers who can't cough up that much cash up front, lenders want a PMI policy to cover them if you default on the mortgage. That's right, you buy insurance to protect them from risk. Unfortunately, the PMI premium increases your monthly expenses and make you slightly less desirable to the lender. For this reason, most borrowers try to avoid PMI.
There are times when it's wise to make a down payment of smaller than 20 percent and pay for PMI - like if you intend to remodel a house soon after you buy it. If the remodel increases the value of the home, you'll have more equity (cash) in the house. The increased equity could bring you to the magic 20 percent threshold at which the PMI goes away.
It works like this. You buy a cute little Craftsman bungalow for $300,000 with 10 percent (or $30,000) down. You remodel it so that a year later it's worth $330,000, which is $30,000 more than your mortgage (equity). With that additional equity, you now hold 20 percent of the home's value and can have the PMI removed.