In today's home buying market, the number and nature of available loans can be overwhelming. Following are explanations of the major and not-so-major types of mortgages you may encounter in your search.
This is the oldest, most easily understood type of mortgage. The interest rate and payment amount remain fixed for the life of the loan, typically 30 or 15 years. If you sign on at 10 percent, you will pay 10 percent when you make the last payment or sell the house.
Two mortgage programs worth considering are government-sponsored programs insured by the:
- Federal Housing Administration
- Veterans Administration
In a seller's market, however, VA or FHA loan programs may not be a workable alternative to conventional financing. Besides the additional fees, the loan application processing time is longer than for conventional loans.
Thirty-Year Mortgage: Most common length of mortgage.
Fifteen-Year Mortgage: The 15-year mortgage enables borrowers to repay their loan more quickly, while building equity faster and paying less interest over the life of the mortgage. Additional advantages of the 15-year plan include:
- The payments are fixed and level.
- The interest rate is usually lower than a longer-term loan.
- You pay off the mortgage sooner than a longer-term loan.
- You save considerable interest over a longer-term loan.
- Payments are fixed at a considerably higher rate.
- The average actual life of a residential mortgage is 7 to 10 years. The shorter your time frame, the less significant the benefits of the 15-year loan.
- Shorter loans work best for those in lower tax brackets, because there's less advantage in the higher interest write-offs of a longer-period loan.
They are best suited for buyers whose monthly payments won't be a problem and who don't intend to remain in their homes for more than a dozen years. 
Up until recently, all mortgages were for a fixed term with a fixed interest rate. A $100,000 mortgage at 10% interest carried the same monthly fee for 360 months. More recently, lenders have offered a vast array of adjustable or variable-rate mortgages, in which the interest rate - and the amount of monthly payments - change over time, usually upward.
Indexes: ARM interest is tied to a specific market rate and changes periodically over the course of the loan. How much and how often it changes depends on the lender's specific policy and the index being used (i.e. Treasury Bills, 11th District Costs of Funds, and LIBOR). Lenders use several formulas to calculate rates, all pegged to some well-established, well-known statistical measurement of the economy. This measurement is an index for the lender's interest rate. If the index moves, your interest rate will also move.
Margin: The margin, or spread, is the profit the lender adds to the index rate to determine what your adjusted mortgage rate will be at each periodic review.
Adjustments: Most lenders offer ARMs that are adjusted either every year (a one-year ARM) or every three (a three-year ARM); others are adjusted every three or six months. When the time comes to adjust your loan, the lender looks at the movement of the appropriate index during the adjustment period. If the index has moved up, you pay more; if it has moved down, you may pay less. The actual adjustment is calculated by a formula that is often lender-specific.
Caps: The capping system has become more standardized over the past several years and is now fairly uniform, chiefly because the secondary market requires capping. There are two caps that affect ARMs:
- The cap that limits the periodic adjustment of your loan interest and payment. (2%)
- The cap that limits the total adjustments for the life of your loan. (6%)
Lenders typically limit periodic adjustments to 2 percent at each review, and lifetime adjustments to 5 or 6 percent. If your ARM rate starts out at 8 percent, it will never increase more than 2 percent per adjustment, and will never exceed 14 percent over the life of the loan.
Many prefer the certainty of a fixed-rate mortgage, but when interest rates are high, some borrowers can't qualify for a fixed-rate alternative. As a result, borrowers who can't afford the fixed-rate loan may find the ARM their only option.
If the ARM index goes down, your rate goes down automatically, and perhaps your monthly payments will go down too. That depends on the margin (reductions usually being capped in the same way as increases). With a fixed-rate mortgage, the only way to take advantage of declining rates is to refinance, and that's a costly process.
Be aware that many lenders apply more conservative underwriting standards to ARMs than they do to fixed-rate mortgages. For example, some lenders will insist that monthly housing payments for ARM borrowers not exceed 25 percent of their income, but they will qualify fixed-rate borrowers whose payments are as much as 28 percent of income. The rationale is that it is better for ARM borrowers not to start out on the edge of their affordability limits, since there's a certain risk that their mortgage payments will increase.
The convertible mortgage represents something of a compromise between the fixed-rate and adjustable-rate mortgages. It's designed for those who want the advantages of the ARM but also want to limit the risk of rising rates. The buyer starts out with an ARM, with an option to convert to a fixed-rate mortgage at specified points during the loan term.
Most lenders will not simply convert you to whatever the prevailing fixed rate when you are ready to switch. Conversion formulas, which vary from lender to lender, are generally complicated. To determine how they work, ask a lender what the conversion rate would be today for an ARM borrower who decided to convert. In most cases, the conversion rate will be higher than the same lender's fixed rate.
That doesn't mean that the convertible option isn't sometimes worthwhile. The conversion should involve less paperwork and be less costly than a straight refinancing. But you need to know whether you'll have to pay any points or other fees at the time you convert. If you will, consider how those costs would compare with the cost of refinancing.
Whether the conversion option works for you depends in part on how much of a premium you'll pay in up-front fees and higher rates. It also depends on how long you plan to be in the home. If you're going to occupy the house for only a year or two, it's unlikely that you'll be able to recover the costs of refinancing before you move. Obtaining an ARM with the conversion option might enable you to get a low rate at the outset, knowing that you could lock in a rate, should the interest rate trend turn against you. That might be a security worth having, especially if you don't have to pay a hefty refinancing fee in order to get it.
There is no easy way to determine whether the conversion option makes sense for you. Give it consideration if minimal fees are required, and the converted ARM interest rate is near the same as fixed conventional loans.
ARM disclosure requirements are extensive. Under a federal law passed in 1988, lenders must supply loan applicants with:
- Exhaustive information about the index and its past performance
- Examples of what will happen to your mortgage payments under assumed worst-case rate changes during the adjustment period
When the lender's cap limits payment adjustments to less than interest adjustments, the difference will be added to the principal balance of your loan. Known as negative amortization, it means that instead of decreasing month by month, your loan actually increases. Not a smart debt strategy.
- Government-sponsored programs insured by the Federal Housing Administration.
- Offers low down payment programs for borrowers. (3% down on the first $25,000 of the purchase price, and 5% down on any amount above that.)
- Offers a fully assumable loan at the original rate and terms.
- Enhances the marketability in a seller's or high interest rate market.
- Seller is required to pay part of the closing costs that are normally considered a buyer's expense.
- Maximum loan amount is limited in many markets.
- Processing, approval, and funding are slow.
- Government-sponsored programs, Veteran's Administration
- Do not require down payments from the borrower.
- Maximum loan amount is limited by the borrowers' qualifying income.
- Typically half a percent or more below prevailing market rates.
- Offers a fully assumable loan at the original rate and terms.
- Seller must pay a large portion of the closing costs.
- Processing, approval, and funding are very slow.
- Available only to veterans, those currently in the service, and their spouses.
- Unless formally assumed, the original borrowers remain liable.
This scratches the surface of what is offered under the government-sponsored mortgage umbrella. Other FHA loans, such as Single-Family Rehab Mortgage Programs and Energy Efficient Mortgages, also provide government-backed insurance put into specialized programs focused on meeting the needs of people in specific situations. It allows would-be homeowners from differing financial and social backgrounds to become homeowners in a market that wouldn't otherwise cater to them.
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