Types of Mortgages

In today’s market, there are numerous types of mortgage loans that consumers can use to obtain financing for a home purchase.  Let’s take a closer look at each.

Fixed Rate Mortgage.  This is the traditional form of mortgage.  It offers the consumer a fixed interest rate and fixed monthly payments for the life of the loan, typically 15 or 30 years.  A portion of the monthly payment goes toward interest and the remainder goes toward the principal.  Over time, the portion allocated to interest gradually declines and the portion allocated to principal gradually increases until the loan is completely repaid.

Biweekly Mortgage.  This is a variation of the Fixed Rate Mortgage in which the payments are scheduled every two weeks instead of once a month.  Each payment is one-half of the normal monthly rate.  Due to the higher frequency of payments, the borrower will actually pay off the loan sooner and pay less in total interest costs.

Adjustable Rate Mortgage (ARM).  As the name suggests, in this type of loan the interest rate is not fixed and adjusts over time.  The interest rate is usually benchmarked against a market interest rate index, such as the Prime lending rate established by the Federal Reserve.  For example, the loan may use an interest rate that is “3 percentage points above Prime.”  Adjustments to the interest rate are done at specific intervals, typically every six months or once a year.

It is important to understand that monthly payments on an ARM change along with any change in interest rate.  If interest rates decline, then the borrower will owe less each month.  However, if interest rates increase, the borrower will owe more each month on the same loan.  In this way, the borrower using an ARM assumes a significant amount of interest rate risk.  This is why the initial rate on an ARM is typically two to three percentage points below the current rate on a fixed rate mortgage.

A potential risk associated with an ARM is “negative amortization.”  For example, if the ARM has a built-in payment cap (such that the borrower’s monthly payment cannot change by more than a certain amount at any adjustment period) but interest rates have increased to a point where the monthly payments are not large enough to pay the current interest on the loan, then this shortfall is added to the mortgage balance.  So the borrower ends up with a higher unpaid mortgage balance at the end of an adjustment period than he had at the beginning of the period.  Clearly, this isn’t desirable and borrowers using an ARM need to be aware of this possibility.

Convertible ARM Mortgage.  This is an ARM that allows the borrower to convert the loan to a fixed rate loan if interest rates decline.  Typically, this option is only available for the first five years of the loan.  The borrower must pay a fee for the conversion, and typically the interest rate drop would have to be significant to compensate for the conversion fee.  Generally, the interest rate on the converted loan will be one-quarter to one-half percent above the current interest rate on fixed rate loans.

Balloon Mortgage.  In this type of loan, the borrower makes payments that are based on a fixed rate 30-year term loan.  However, he only makes those payments for the first five or seven years of the loan.  After that, the entire loan balance is due.  This is referred to as the “balloon” payment.  This type of loan makes sense for a borrower who plans to sell the home before the balloon payment is due.

Two-Step Mortgage.  The two step mortgage is often referred to as a 5/25 or 7/23 mortgage.  It is the combination of a fixed rate mortgage and an adjustable rate mortgage.  The term is 30 years, and the borrower receives a fixed rate during the first five or seven years. Thereafter, the loan converts to an ARM.  This type of loan, similar to the balloon mortgage, make sense when the borrower plans to sell the home before the initial five or seven year period expires.

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