Mortgage Terms Explained
by Chris Cooper
When you are hunting for a mortgage, you will find that there are many different types of mortgages available. I will list some of the more common ones and their uses.
15 vs 30 Years
Your mortgage term can be just about anything you choose. 15 and 30 year terms are popular these days, although 10 and 20 years also are available.
The shorter the term, the lower the interest rate. But the main attraction of shorter term mortgages is the money you save.
For example on a $200,000 mortgage with a fixed 4.5% rate, you would pay $1013.38 a month for 30 years and $1529.99 a month for 15 years. Over 30 years you would pay $364,816.80 versus $275,398.20 over 15 years, a savings of $89,418.60 or 24.5% in interest.
If you cut a very conservative quarter of a percent off for reducing the lender's exposure by 15 years, your savings will be nearly 26%.
Adjustable Rate Mortgages (ARM )
ARM’s are mortgages whose rates adjust according to the terms of the contract you made with the lender.
Usually interest rates are fixed for the first 1, 3, 5, 7 or 10 years. After that period is up, rates will be allowed to fluctuate within the limits of your contract with the lender.
Terms are usually 15 or 30 years (although you can negotiate just about any duration you want). There can be a balloon involved.
Because the lender is not taking as big a risk on losing money if interest rates rise, these loans will have a lower initial rate than a fixed mortgage. The lowest rates will be for 1 year ARM’s and will go up accordingly.
Many people will take out an ARM even in period of low rates, such as now, because they get even lower rates and are able to afford more house. However, the borrower is taking the risk that he can still afford the house after the rates are free to rise.
It used to be common for the contract to limit fluctuations to 2% a year. However, 5% swings are becoming more the norm. Depending on what happens to interest rates, you might find yourself priced out of your house. Of course, you could renegotiate if rates start to go back up.
The average homeowner owns his or her house for approximately 7 years. If you plan to move before the initial fixed term of the ARM is up, it’s a good choice. If you plan to stay longer than ten years, a fixed rate might be a better option.
A balloon mortgage is one that is not completely paid off at the end of its term.
For example, you might obtain a 15 year fixed rate mortgage that allows you to pay less than the normal amortization schedule would call for. At the end of the 15 years, you will still owe a portion of the principal. How much depends on the terms of the contract.
An interest only mortgage is an example of this type of loan. In the case of an interest only loan, the balloon will be the full amount you originally borrowed.
This type of mortgage allows borrowers either to afford more house then they otherwise could buy or it reduces their monthly costs, allowing them to spend or invest their savings elsewhere.
Again, if you are planning to move before the balloon is due and your proceeds from the sale are enough to cover the balloon, this might be a good idea. However, you face the very real possibility of having to come up with cash when you sell to cover the balloon, especially if you have to sell at a time of declining housing prices.
A biweekly mortgage is one where you pay half of the normal mortgage payments every two weeks. Since you are making 26 payments a year, rather than 24, you wind up paying off the interest sooner and saving considerable interest.
Take the example of a $200,000, 4.5% fixed rate mortgage with a 30 year term. The normal payment would be $1013.37 a month.
The biweekly amount is $506.91. But the payoff is huge. Your loan will be paid 5 1/2 years earlier and you will save 28% or $32,639.75 interest.
You can set up your own biweekly mortgage plan with your existing mortgage, assuming there is no prepayment penalty (which usually only applies the first few years anyhow). Simply send in or have your bank debit your checking account for one half your mortgage payments every two weeks. There should be no extra costs or fees to do this.
Or you can reach a similiar result by dividing your monthly payment by twelve and adding that to your payment. In this example that would come out to be an extra $84.44 a month.
The secret is that any prepayment, no matter how small will result in saving in interest and a shorter payment period.
Bridge loans are used in real estate transactions to cover the down payment on a new home, when the borrower has equity in his old home, but not enough cash.
It is generally a short term, interest only loan that is repaid when the homeowner sells his old house.
Most mortgages are conventional, the terms just vary. A conventional mortgage to most people is a 15 or 30 year fixed rate mortgage with at least 20% down.
These are really loans that carry a higher interest rate than a normal mortgage. They allow you to borrow the money to build a house and are converted into a mortgage once the house is finished.
FHA (Federal Housing Administration)
The FHA is a branch of the Housing and Urban Development (HUD) Department. It is a depression era creation, meant to make it possible for people to buy homes at a time when banks where not granting mortgages.
The FHA insures loans up to certain set amounts, which vary with the region of the country and the type of loan. Right now the guarantees run from about $160,000 for a one family house to somewhat over $300,000 for a four family home.
This type of mortgage is designed to help low and moderate income people become home owners. It requires low down payments and has flexible lending requirements.
If the borrower defaults, the government steps in and pays the guarantee. This makes it easier for lenders to write mortgages they would otherwise refuse.
Fixed rate mortgages have interest rates set for the term of the mortgage, which can be anywhere between 5 to 30 years.
Although they can be interest only or have a balloon, they usually are conventionally amortized mortgages.
At times like now, when rates are low, most homeowners want to lock in the low fixed rates. They are popular when rates are falling, not so popular when they’re high or going up.
This type mortgage is a very good idea if you're planning to live in your house for a while.
Home Equity Line of Credit
A revolving credit line secured by your home. Because it is a mortgage, it carries a lower rate than other forms of credit and is tax deductible.
It differs from a second mortgage in that it is not for a fixed term or amount and can be kept in effect as long as you own your home.
This is used most frequently for debt consolidation and can be useful if you rip up your credit cards and use the money you save on interest to invest.
Interest Only Mortgages
This is just what it says. You only pay interest, the principal is never reduced.
This is the grand daddy of all balloon mortgages and you taking a big risk that your house depreciates in value rather than the other way around.
You could very well have to come up with extra cash at closing.
The payments are much lower than on a normally amortized mortgage and if you have the discipline, it can be a useful financial planning tool.
Mortgage loans over $322,700 (the limit is periodically raised). Otherwise, the mortgage can be fixed or variable, balloon, etc.
Rates are usually a little higher than for smaller loans.
No Doc or Low Doc Mortgages
This refers to the mortgage application, not to the mortgage itself. Business owners, people living off investments, salesmen and others whose income is variable might use low or limited documentation mortgages.
Very wealthy borrowers or those who want substantial financial privacy will sometimes use the no doc option.
In either case, in spite of their names some documentation is required. The lender will accept nothing less than excellent credit and even then you will pay more for the privilege.
No Money Down Mortgages
These come in two flavors: FHA type loans that allow low or moderate income borrowers to buy a house with little or nothing down and the 80-20 plans, where wealthier borrowers with little money saved up finance 100% of the purchase price.
Under the 80-20 plan a first and second mortgage are issued simultaneously. The borrower avoids having to buy mortgage insurance. The two loans are designed to cost less than an 80% loan plus the insurance, otherwise they make no sense.
If the borrower puts some money down, you will see the mortgage referred to as 80-10-10 (the last digits will be the percent of down payment) or some similar number.
It is mostly used by borrowers who haven’t saved enough for a down payment or by those who have the money, but would rather use it for other purposes.
This technically means getting a new mortgage at different, hopefully better terms. A lot of people use it interchangeably with obtaining a second mortgage or line of credit; in other words tapping into the equity of their house.
Secondary financing obtained by a borrower.
They can be fixed in amount or take the form of a Home Equity Line of Credit, which is simply a revolving credit line secured by a house.
Homeowners use these forms of financing to consolidate bills, do home renovations, put their kids through college, etc. They are tapping into the equity they have in their house to use for other things.
This is not necessarily a great idea. You must take firm control of your finances when you start doing this or you risk either losing your house or having to raise cash to pay the mortgages off when you sell.
If done properly, you can pay off your debt at a lower, tax deductible rate and invest your savings.
VA (Veteran’s Administration) Mortgages
The VA provides mortgage guarantees to active duty and ex-servicemen who meet certain eligibility requirements.
Like with FHA loans, the government guarantee makes it easier for low and moderate income veterans and active duty service personnel to obtain mortgages.
The current VA guarantee is $89,912. It is raised periodically.
If you want to bet house prices will rise, some lenders will lend you up to 125% of the value of your house. If you’re right, you’re okay. Otherwise be prepared to have your checkbook available when you sell your house.
I’m sure that there are other financing options available that I haven’t covered and don’t even know about. But most of the main financing types are covered here.
About the Author
Chris Cooper is a retired attorney who is very familiar with debt, being in it too many times in his life. These articles pass on some of the knowledge he has gained striving to become debt free. He is editor-in-chief of http://www.credit-yourself.com a website devoted to debt management