Types of Home Mortgages
There are three basic types of mortgages that lenders offer borrowers when purchasing or refinancing a home.
(1) Fixed Rate Mortgages: A fixed rate mortgage carries a set interest rate that will remain constant for the length of the mortgage. If you have a 30-year mortgage, the rate you pay will be fixed for all 30 years. At the end of the 30th year, if payments have been made on time, the loan is fully paid off. To a borrower the big advantage is that the rate will remain constant and therefore the monthly payments will remain the same. It reduces the risk that the borrower will be called upon to make higher interest payments than the purchaser anticipated. However, lenders usually demand a higher interest rate on a fixed rate loan, translated into higher monthly payments than the initial rate and payments on an adjustable or balloon mortgage. The lender is taking on the risk that interest rates will rise and the mortgage company will get stuck carrying a loan at below market interest rates for much of the 30 years. If the rates fell, the homeowner can always pay off the loan, usually by "refinancing" the house at the then lower interest rates.
(2) Adjustable Rate Mortgages: An adjustable rate mortgage, known as an "ARM", offers a fixed initial interest rate and a fixed initial monthly payment. However both are "fixed", not for the life of the loan, but for a much shorter period of time such as 6 months to 5 years. With an ARM, after the initial fixed period, both the interest rate and the monthly payments adjust on a regular basis to reflect the then current market interest rates based on an index. Each lender can use its own index and formula, and some may be more or less advantageous to borrowers. Each lender may also use different adjustment periods. For example, some ARMs may be subject to adjustment every 3 or 6 months, while others may be adjusted just once a year. In addition, some ARMs limit the amount that the rates can fluctuate on any adjustment, perhaps to no more than ½ of one percent on any adjustment date. An ARM usually carries a lower initial interest rate and lower initial monthly payments for the buyer in exchange for the homeowner taking on the risk that rates may rise in the future. This means both the rate and monthly payments could adjust upwards. As an inducement to bring in new borrowers, some lenders may offer low "teaser" introductory discount rates for up to 12 months of a loan, and thereafter jump to the actual rate of the loan along with a corresponding payment adjustment. Most ARMs also carry a "cap", which is an upper limit on the rate that may be charged the homeowner. For example, if the initial rate on your loan is 6% and the cap is 11%, if rates climbed to 15%, the maximum interest rate that could be charged on the loan would be 11%.
(3) Balloon Mortgages: A balloon mortgage has a fixed interest rate and fixed monthly payment, but after a fixed period of time, such as 5 years, the entire balance of the loan becomes due at once. As a practical matter, the homeowner is unlikely to have enough cash to pay off the entire loan balance after 5 years, so he will have to arrange for a new mortgage. If he can’t get another mortgage, the homeowner is stuck and may lose the house. Balloon mortgages are usually a last resort for those who can’t qualify for a standard fixed or adjustable rate mortgage.
Another type of mortgage, a "home equity loan", is typically used by homeowners to borrow on some of the equity they have built up in their homes. These debt instruments usually involve a "floating" or adjustable rate of interest and are amortized over a period of years.