Types of Mortgages

There are various types of mortgages offered by lenders. The type of mortgage a borrower selects depends upon many factors, such as how long are they planning to keep the house, what are the other investment plans and the overall available budget? Two of the most common mortgages are:

• Fixed-rate mortgages
• Adjustable-rate mortgages

Fixed-rate mortgages
Most people get fixed-rate mortgages, as it makes budgeting and planning easier. Under this scheme, the borrower pays a fixed rate and monthly payment, normally for a 15-year or 30-year period or term. They are popular because the borrower does not have to worry about the interest rate or payment changing. You can not take advantage of a fall in the interest rate unless you refinance, which comes with closing fees.

Adjustable-rate mortgages
Interest rates and monthly payments differ depending upon the prevailing interest rate and the preset interval of change that the borrower has agreed to in his closing document. For a certain initial period of the mortgage, the borrower pays a fixed rate. And, the adjustments to the rate are made on a preset time period. The most popular is 5/1 ARM, where the borrower pays a fixed rate for the first five years and then the rate is adjusted annually thereafter. Other options are 3/1, 7/1 and 10/1.

However, you do not have to worry about extreme changes as ARM rates usually come with a cap, such as a period cap, lifetime cap and payment cap. These caps are limits on how much the rate can change during a time period.

Interest-only Mortgage
Borrowers with an ARM who take out an option to just pay interest for a specified period is called an interest-only mortgage. After the end of such time period, the interest rate is adjusted to the prevailing rate of the market and the borrower can also choose to pay the principal too.

ARM is beneficial for people who earn fluctuating income or people who can get a better return by investing the money, so they can save it into alternative investment schemes. A word of caution: the borrower may want to reserve his right to change the ARM into a fixed-rate mortgage, just in case the interest rate rises unexpectedly.

Other mortgage types

Jumbo mortgage
A non-conforming loan exceeds the single-family loan limit set by Fannie Mae and Freddie Mac, which changes annually. Borrowers who require funding above this limit need a jumbo mortgage. These mortgages attract a higher interest rate than "conforming" loans. It gives the borrower the opportunity to buy a larger, more expensive home. But, the borrower will be required to pay a higher interest rate in exchange for the lender's higher risk.

Two-step mortgages
The borrower has the option of combining the fixed rate and adjustable rate mortgage under the two-step mortgage. The borrower may come across 2/28, 5/25 or 7/23. Here the borrower pays a fixed rate and payment for an initial period. Then, one adjustment is made to the interest rate for the remainder of the loan term. It helps borrowers with damaged-credit to buy homes and to re-establish better credit. However, there is a catch, if the borrower is unable to fix his credit score before the rate adjustment – he may be stuck in a high-rate loan for a long time.

Balloon mortgage
The borrower can receive lower rates and payments for a specific period of time ranging usually between three to 10 years. However, at the end of that time, the borrower is required to pay off the principal balance in a lump sum. It may be prudent to ask if the mortgages can be converted to fixed-rate or adjustable-rate loans after the initial years. This type of mortgage is ideal, only if the borrower has plans to sell his homes before they get to the due dates or is considering refinancing the balances into new mortgages. But if your plans change, as they do many times, you may find yourself paying a lump sum or refinancing the balance, at a time of higher interest or a point where you can least afford it.