Consider this: Most people will spend days, weeks, even months researching different homes before putting in their first offer. Yet when it comes time to paying for that house, most people will only spend minutes researching loan products before picking out their mortgage.
People tend to assume the 30-year, fixed rate mortgage is the best option. They’ll typically call the bank where they already do business (e.g. the bank that holds their checking/savings account) and apply directly. But did you know the loan you pick can cost or save you thousands (even tens of thousands!) of dollars over the life of your loan? Don’t overlook the importance of your mortgage.
Before you lock in a mortgage, spend some time educating yourself about the pros and cons of different loan products. As a primer, we’ve put together a short overview of the most common loan types below.
Fixed Rate Mortgage
The interest rate is fixed for some period of time – from 5 years up to 50 years. The most common types are 15- and 30-year fixed rates (the “conventional” loan). If you go for a fixed rate mortgage, you have the security of knowing how much you’ll pay every month, year in and year out. If rates go up, you won’t pay more. If rates drop significantly, you can refinance into another lower-cost, fixed rate loan. Most people opt for the fixed-rate mortgage if they plan to stay in their property for more than five years.
Unlike a fixed rate mortgage, the interest rate on an ARM can fluctuate from year to year. Usually, interest rates for ARMs are lower because they come with higher risk over the long-term. Many lenders will offer a 5-year ARM in which the interest rate is fixed for the first five years of the loan, and then fluctuates thereafter. If you aren’t planning to stay in the same home for more than 5 years, this is a great option. You lock in a lower interest rate now, and if the rates fluctuate down the road (beyond the initial five years), it won’t matter to you because you will have sold the property.
This type of loan allows the borrower to pay interest only for a period of time before paying principal and interest. This loan isn’t common for the purchase of a new home, but is often used as a second loan—like a home equity line of credit—after a person has owned a home for a while. It works like this: Say you take out a $100,000 loan that amortizes over a 10 year period. You might pay interest only for the first five years, but at the beginning of year six, your monthly payments would skyrocket to include both principle and interest (with principle payments spread over 5 years, instead of the full 10). Before taking out an interest-only ARM, you should be confident that you can afford the full monthly payments during the latter half of the loan.
One-year Treasury ARM
This type of ARM has a fixed interest rate for one year only before it become adjustable. The new rate is calculated by the U.S. Treasury average index plus the loan margin. If rates go down, you can benefit with 1-year Treasury mortgage because rates are lower than other fixed-price mortgages and ARMs.
This mortgage allows a person to convert their ARM into a fixed-rate mortgage after some period of time. Few people go this route; instead, most refinance into a conventional loan. The only real benefit is the convertible ARM allows people to save the up-front costs of refinancing.
A balloon mortgage is when a person pays a very low interest rate and small amount toward principle every month, but after a certain period of time (typically, 10 years), a “balloon” payment will become due equal to the principle balance of the loan that had not yet amortized. Let’s use an example:
Say you take out a loan for $400,000. Through paying principle and interest each month, you pay the loan down to $300,000 over the first ten years. Now, heading into year 11, you’ll have a balloon payment due. In other words, you’ll owe the bank a $300,000 lump sum payment.
Few people use these loans today, but they can make sense for someone who has a high salary/savings and/or if they own a home in a hot market and anticipate they’ll be able to sell the home for a significantly higher price—thereby putting the sales proceeds toward the balloon payment. But this a particularly risky loan product if your life or the market changes and you cannot afford the balloon payment when it becomes due. In this scenario, you might be able to refinance into a different type of loan but the refinancing terms may come at a higher cost.
There are many types of hybrid mortgages, including: Option ARM mortgages, Combo Loans, and Mortgage Buy Downs.
- An Option ARM (sometimes called a “pick-a-pay” mortgage) is a complicated mortgage type, and, like other ARMs, the interest rate fluctuates periodically. Yet the interest rates are tied to one of many major mortgage indexes, like the LIBOR, MTA or COFI. Option ARMs allow borrowers to choose from one of four payment options, tied to any one of the approved mortgage indexes.
- A Combo Loan is when a person has both a first and a second mortgage. The first mortgage is usually for 80% of the principle, and the second loan can be used for home renovations/repairs or to pay down additional principle in order to avoid paying private mortgage insurance (PMI). Many first-time homebuyer programs will use a Combo Loan program, with the second loan equivalent to 15-17% of the loan balance, so the home buyer only has to put down 3-5% when up front. One thing to know is that the first mortgage will always supersede the second mortgage, so if you default, the holder of the second mortgage gets repaid last.
- A Mortgage Buy Down is when borrowers pay an upfront fee (usually equivalent to 1% of the purchase price) to lower the interest rate on their mortgage by a set amount. For example: if you take out a loan for $300,000, instead of paying a 4% interest rate, you might be able to get a 3.5% interest rate by paying a “point,” which is equivalent to 1% of the home loan (in this case, it would be equivalent to $3,000). That $3,000 may seem like a steep fee to pay up front, but the lower interest rate can save you tens of thousands of dollars over the lifetime of your loan.
So which loan is right for you?
It’s important to compare all of the types. Look at all of the deals, the fees associated with each of the mortgages, and the rate terms that you’re being offered. And always, always be sure to check in with a few different lenders to compare your options.