Loan Types
Interest Rate: Fixed vs. Adjustable:
The two most common loan types are called Fixed Rate mortgages and Adjustable Rate Mortgages (ARM).
The choice between them is all about how comfortable you are with the risk that interest rates will rise during the life of your loan.
- Fixed Rate Mortgage: this is the most popular type of mortgage, and is the standard against which all other loans are measured.
- How It Works: the interest rate and monthly payment amount are set at the beginning of the loan and stay the same for the life of the loan (generally 15 or 30 years).
- What They Are Called: 15 Year Fixed, 30 Year Fixed
- Advantages:
- No Risk of Change: Your payments won’t change, regardless of interest rate fluctuations, or inflation.
- Easier to Budget: if your monthly payment is $665 in month 1 of your loan, it will still be $665 25 years from now (when both your income and inflation will most likely have increased).
- Easier to Understand: fixed loans are the easiest ones to understand. There are two types (15 and 30 year) and your rate and payment never change.
- Disadvantages:
- Higher Interest Rate: Fixed rate loans generally have higher rates than the initial rates of comparable ARMs.
- Higher Monthly Payment: since the rate is higher than on a similar ARM, so is the monthly payment
- Harder Qualifications: borrowers have to have the income and credit scores to qualify for the higher payments
Adjustable Rate Mortgages: these loans are increasingly popular, both with first-time buyers and sophisticated investors.
- How It Works: the interest rate for these loans starts with an initial period (sometimes as short as 1 month) of being fixed, then adjusting either every 6 or 12 months afterward.
Adjustments: ARMs adjust to follow the changes in a major economic index. At the adjustment date, the lender checks the index the loan is tied to, then adds a margin, and recalculates the interest rate the borrower will pay for the period (usually increasing it).
Most ARMs adjust based on one of three major economic indices:
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The 11th District Cost of Funds Index (COFI): the interest rate that financial institutions in the western US are paying on deposits they hold
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U.S. Treasury Bills: the weekly constant maturity yield on the one-year T bill (as tracked by the Federal Reserve Board).
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The London Interbank Offered Rate (LIBOR): the rate international banks charge each other on large loans
Limits: the good news is that these loans have limits on extreme adjustments in the rate, called caps. The most common form of caps are:
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Periodic Rate Cap: frequently these are annual caps that limit how much the interest rate can rise at any one time (for example, 2 percentage points over a year). (These sometimes don’t apply to the first adjustment, which can be a steep one.)
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Lifetime Cap: caps the amount (in percent) the interest rate can rise over the lifetime of the loan (15 or 30 years).
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Payment Cap: limits the amount (in dollars) the monthly payment can rise over the lifetime of the loan (15 or 30 years)
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What They Are Called: there are lots of types of ARMs, the common ARM is a One Year ARM, with 1 year of fixed interest rate and payments, then adjusted annually.
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Hybrid ARMs: ARMs with a longer fixed period are often called hybrids. Common loan types are the 3/1, 5/1, 7/1 and 10/1, with the 5/1 being the standard. These have 3,5,7 or 10 year fixed initial periods, then adjust annually.
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These loans allow you to pay off the principal as well, so for borrowers with fluctuating income (like commission-based salespeople), you have more flexibility in deciding how large your payment is and how much equity you want to build at what speed.
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Convertible ARMs: some ARMs can be converted to fixed rate mortgages upon a certain event (usually tied to interest rates or a period of time)
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Negative Amortization: these are risky loans where you can end up owing more money than you did when you started.
This happens because the payments are set so low, they don’t cover even the full amount of interest due (like the minimum monthly payment on some credit cards).
Then every month, the rest of the interest due gets added to the principal and you can quickly end up in a situation where you owe more money than the property is worth.
So even if you sell the property, you won’t be able to cover what you owe. This is almost always a bad choice for a borrower, if your mortgage broker or loan officer offers a “neg. am.” loan to you and says it’s a great deal and that the payments will be really low, make sure you completely understand the risks involved.
Advantages:
- Lower Initial Rates: ARMs generally have a lower starting interest rate than comparable fixed rate loans
- Lower Monthly Payments: because the rate is lower, the monthly payment is generally lower than for a comparable fixed rate loan.
- Easier Qualifications: ARMs are usually easier to qualify for, allowing people to borrow more money than they could with a fixed rate mortgage.
- Greater Flexibility: ARMs offer lots of different rate/payment combinations, so the chances are that you’ll find one that works for you.
- No Need To Refi: in a market when rates are falling, your loan rate will adjust downward, so you get the advantages of a cheaper loan without having to go through a refinance.
- Disadvantages:
- Risk, Risk and Risk: a lot of people are very uncomfortable with the risk that interest rates will rise, increasing their monthly payments.
Many borrowers (and especially lots of first-time buyers) are overwhelmed by all the options and just want to get a fixed rate loan so they know that their mortgage payment will be exactly $X every month from now until it’s paid off.
That’s not the case with an ARM; there’s always a chance that while you thought you’d only keep the property and loan for 5 years, you end up staying into the 6th year and your 5/1 ARM adjusts upward and your payment goes up. (Though in this case, you would probably refinance.)
It takes a lot more effort to figure out the terms and financial consequences of each type than to simply sign up for a fixed rate loan.
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Balloon: as ARMs have become more popular, balloons have fallen from favor, to the point where many lenders no longer offer them
- How They Work: balloons are short term mortgages that have a fixed payment for the term of the loan (most are 5 to 7 years). At the end of the term, the remaining balance of the loan is due in full (the balloon payment).
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What They Are Called:
- Balloons
- 7/23 or 5/25 Convertible: these are balloon loans which can be converted to a 30 year fixed rate loan at the end of the term (for a price, usually 3/8ths of a point) as long as you meet certain criteria such as having made the past 2 years of payments on time.
- Deferred Interest Loans: these are a version of balloon loans where the initial payments go primarily toward paying down the principal and the interest keeps collecting (and eventually comes due in a lump-sum payment).
- Advantages: Balloons generally have interest rates lower than fixed rate mortgages and are easier to qualify for.
- Disadvantages: they are short term mortgages only and borrowers are forced to refinance to another loan at the end of the term.
Conventional vs. Government-Guaranteed Mortgages:
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Conventional Mortgages: loans issued by mortgage bankers, portfolio lenders and other business financial institutions (credit unions, etc.) and not guaranteed by any government entity are called “conventional.”
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Government-Guaranteed Mortgages: any loan insured by the FHA, VA or RHS. These loans generally have low or no down payment requirements and are designed for borrowers with low to moderate income. See Government and Private Agencies for more information.
Conforming vs. Jumbo:
Sometimes size really does matter:
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Conforming Loans: loans that have terms and conditions that are within the guidelines set by Fannie Mae and Freddie Mac. These guidelines include:
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Maximum Loan Amount ($417,000 for the 2006 single-family property in continental US)
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Borrower Credit & Income Requirements
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Down Payment
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Property Type
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Loans which meet these criteria can then be bought, “pooled” together as securities, and sold on the secondary market.
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Jumbo Loans: loans for amounts larger than Fannie Mae and Freddie Mac’s annual limit. They usually have somewhat higher interest rates than conforming loans. Loans above $650,000 are sometimes called “Super Jumbo” Loans.
Assumable vs. Not:
When someone takes over the existing mortgage on a property, it is called “assuming” a mortgage.
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How It Works: The seller has to agree, and then the borrower must qualify for the loan, pay for the transfer administration, new title and appraisal fees at a closing, and cover the difference between the selling price and the remaining balance of the loan with either cash or a second loan.
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Advantages: When interest rates are rising, a mortgage with an interest rate lower than the currently available rates can be a very desirable feature of a property.
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Disadvantages:
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Not all mortgages are assumable.
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The seller can still be held liable. If the buyer can’t make the payments and the lender forecloses on the property but the property sells for less than the remaining loan balance, the lender can sue the seller for the difference.
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Prime vs Subprime:
Your credit score is a critical factor in what kind of loans are offered to you at what rate. Credit scores range from around 300 to almost 900, with the median FICO score being 723.
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Prime or “A Paper” Loans: These are loans for people with good credit history. They have lower interest rates because these borrowers are most likely to pay their loan payments on time and in full. These loans can also be sold on the secondary market.
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Subprime or “B/C Paper:” These are loans for borrowers with lower credit scores (generally 630 or below), or loans for more than the value of the property (125% loans). These loans usually can’t be sold on the secondary market and the lender must hold them in their portfolio.
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Higher Rates: Subprime loans have higher interest rates to reflect the fact that the lender is taking a bigger risk lending money to someone with either a history of missed or late payments, or no credit history at all.
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Higher Fees: Lenders often charge higher and additional fees on subprime loans, some even require the borrower carry a life insurance policy that will pay off the loan in the event of death.
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Prepayment Penalties: Subprime loans are also likely to have a large “fine” if the borrower pays the loan back early (either by refinancing or selling the property).
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Balloon Payments: another possibility is that the lender will require that the borrower pay the entire outstanding amount in a lump sum payment after a certain period (often 5 years).
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Need To Shop Around: if you have a lower credit score (you should check before starting to apply for loans), be prepared to apply with at least two lenders to make sure you are getting a competitive rates: subprime rates vary widely depending on an individual lender’s calculation of the lending risk (they don’t all measure it the same way).
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Special Loan Programs: Some lenders have programs which will lower the loan’s interest rate if the borrower makes all of their monthly payments completely and on time for a certain period.
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Government Agencies: There are programs at the national, regional, state and local level to increase the affordability of housing for low and moderate income borrowers. Check with HUD/FHA local offices to see what assistance is available to you.
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Seller Financing/Wraparound:
There is an uncommon form of financing where buyers who can’t qualify for the full selling price of a property negotiate an agreement with the seller.
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How It Works: The buyer pays a certain number of monthly mortgage payments for the seller (assuming the loan) and gets another loan for the rest of the selling price amount.
So if the selling price is $100,000 but the buyers only qualify for a $85,000 loan, then the buyers would make $15,000 worth of payments on the seller’s loan, then the seller sells the property to them for $85,000 and the buyer gets a loan for that amount.
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Family Sales: This is mostly used when one family member is selling property to another member of the family and the seller wants to help the buyer with the financing.
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Hire a Real Estate Attorney: to keep this kind of agreement from going bad, make sure you have the agreement drawn up by an experienced real estate attorney.