Turn on the TV, pick up the newspaper, and you’ll soon see the latest mortgage come-ons. Teaser rates, introductory one-time offers and exhortations to “Act Now!” can overwhelm you, so let’s cut through all the lingo and simplify things into two general camps: the mortgages known as standard fare, and the more complicated products that merit closer scrutiny.
Types of Mortgages to Scrutinize Carefully
The gold standard in home lending, fixed rate mortgages in terms of 30, 15, or 10 years offer stability in a set payment for the life of the loan and represent more than three-quarters of all home loans. The biggest advantage of having a fixed rate mortgage is that the homeowner knows exactly what the interest and principal payments will be for the length of the loan. That makes budgeting easier because you know that the interest rate will never change for the duration of the loan.
You pay a bit for that stability: the interest rates of fixed rate mortgages can be higher than the interest rates on other types of loans at least early in the life of the loan, so the monthly payments are usually higher as well. It’s worth noting, though, that fixed rate mortgages can protect you if interest rates rise down the road.
Adjustable-rate mortgages feature an interest rate that changes based on a specific schedule after a “fixed period” at the beginning of the loan, which typically ranges from three to seven years. ARMs are a bit of a trade-off: in exchange for the risk of the interest rate increasing over the long term, the homeowner is rewarded with an initial interest rate lower than that of a fixed rate mortgage. Of course there is always the chance that interest rates will fall in the future, but in our current climate of low interest rates, that's less likely.
Many shoppers turn to the many varieties of ARMs because they can enable you to qualify for a higher loan amount. Some homeowners with extremely large mortgages purchase using an ARM and then refinance them each year. ARMs are considered to be rather risky because the payment can change from year to year by a significant amount when interest rates climb rapidly.
Home equity loans are more like conventional fixed-rate mortgages. For instance, a home equity loan uses your home as collateral for a loan of a predetermined set amount. The lender pays out the full amount in a lump sum after approving the loan, and the recipient starts making payments immediately.
To calculate your home equity, take the current (appraised) value of your home and subtract your mortgage amount. For example, if your home is worth $150,000 and you have a $100,000 mortgage balance, you have $50,000 of equity in your home. A home equity loan allows you to borrow up to 80 percent of that equity, $40,000 in this case.
Home equity loans generally carry higher interest rates than the initial rates offered by their sister products, home equity lines of credit (HELOCs). The interest paid on home equity loans is usually tax-deductible, but you should check with a tax consultant about possible exceptions. Some loans include a prepayment penalty clause, which imposes a fee when a homeowner pays off the debt prior to a specified time.
A home equity line of credit, or HELOC, is granted using the same percentage system as a home equity loan, but is issued in the form of a line of credit you can draw from in any amount up to the loan total that you are given. Financial institutions determine the amount of your home equity loan or credit line by subtracting the balance on your mortgage from a certain percentage of your home’s appraised value. Most lenders cap home equity loans and HELOCS at 80% of the home’s appraised value. For example, if a home’s appraised value is $100,000, and the mortgage balance is $40,000, you’d be able to qualify for a $40,000 HELOC.
Home equity lines of credit resemble credit cards in that no interest or payment is due until you actually spend money. In fact, many HELOC providers actually issue a debit card that you can use to access funds. Some lenders charge annual fees for having a HELOC account open, but most only assess accrued interest as you spend the money. Your monthly payment is based on the amount you have spent. As you pay down the balance, the line of credit is replenished.
Home equity lines work well for people who are planning property improvements as well as those who simply want to be prepared for unexpected financial needs. Keep in mind that interest rates can fluctuate on variable rate equity lines, so it might worth a bit higher rate over the life of the HELOC to go with a fixed rate line. Interest on a HELOC ordinarily is tax-deductible up to $100,000 regardless of how it’s used. However, if the HELOC is solely used for home improvements, you might be able to deduct as much as $1,000,000.
Federal Housing Administration loans enjoy a fine reputation as a way for families of modest financial means to buy a home. In the aftermath of the home mortgage crisis, the FHA has tightened up some of its rules, but for many homebuyers, FHA loans are still an attractive option.
FHA loans differ from conventional loans starting with the most basic part of buying a home: the down payment. Down payment requirements for FHA home loans require a minimum down payment of 3.5%, while many conventional mortgages require down payments of as much as 10-20% depending on the lender. FHA loans also require a minimum of 5 years of private mortgage payments, even after a refinance, regardless of down payment size or loan-to-value ratio (LTV).
Anyone can apply for an FHA mortgage loan, but certain homebuyers are ideally suited for this type of mortgage, especially those in the process of re-establishing their credit and applicants with a short credit history. Because of the FHA’s relatively low credit score requirements, these applicants can purchase a home much sooner, instead of waiting to build their credit score. While conventional mortgage lenders look for a credit score of no less than 680, the FHA uses a credit score of 620 to determine whether you can qualify automatically for a loan. Even a credit score below 620 does not disqualify you, as it might with a conventional mortgage.
The federal government offers a couple of other loan programs that might be of interest as well:
If you are looking for a home in the country, the United States Department of Agriculture’s Single Family Housing Guaranteed Loan Program, also known as its Section 502 program, could be perfect for you, provided you’re buying in a qualified rural area. The USDA program is designed for low-income homebuyers buying a rural home and features no down payment, no monthly mortgage insurance premiums, and subsidized interest rates. USDA-guaranteed loans are made by private lenders, but insured by the government.
USDA loans can be used to purchase, refinance, renovate or repair a home. These guaranteed loans offer 100% financing to income-qualified individuals, with a safe, low fixed interest rate. You should be aware, however, that the USDA only guarantees 90% of the loan, which means that 10% of your home loan would be have to be secured by other means. Income eligibility is capped at 115% of your median area income, so check to see if your income meets the requirement using the USDA’s income eligibility calculator.
If you think you qualify, your local USDA office (which you can find at usda.gov under the “Programs and Services” menu) will need to verify your income and debt payments to ensure you can afford a loan. You’ll also have to complete a homebuyer education course. If you can get into a USDA loan, it’s well worth the effort.
If you’re a military veteran, you should also take a look at the Veteran’s Administration loan program. The federal government secures VA loans, so many lenders are willing to offer financing to people with VA approval. Like FHA loans, VA loans do have strict approval requirements for the house you wish to purchase and require stringent inspections.
The VA loan is ideal for first-time buyers. The VA offers first-time homebuyers loans for 0% down, and its credit standards are much more flexible than even private lenders, making it much easier for many first-time buyers to qualify. Best of all, VA interest rates are backed by the federal government and are typically 0.5%-1% lower than the most competitive private rates. The federal guarantee also means that private mortgage insurance (PMI) is not required, shaving even more money off of your monthly payment. For all your eligibility questions as well as the forms you’ll need to start the process, head to the VA’s helpful information FAQ.
Types of Mortgages to Scrutinize Carefully
The risk profile for the following mortgage products makes them a less safe bet for homebuyers. It’s not that these products are bad, but their features mean it’s worth a long look before moving forward.
Balloon mortgages work very differently than a traditional mortgage. For starters, making your monthly payment will not pay off your balloon mortgage by the time the loan ends. Instead a portion of the principal remains and must be paid off in one lump-sum payment, known as the “balloon payment.” While balloon mortgages usually carry a fixed interest rate, the monthly payments borrowers make usually include only the interest on the loan, never touching the principal.
Balloon mortgages are typically given with a 3 to 5 year term, but the monthly payments are figured as if you were paying off a 25 year or 30 year term. After those 3 to 5 years though, the loan balance comes due. This makes for very, very low monthly payments, bookended by one very large balloon payment of as much as 70 percent of the mortgage total.
For example, let’s say you obtain a seven-year balloon mortgage to purchase a home. You’d then have seven years of equal monthly payments at a fixed interest rate. At the end of the seven years, the loan’s remaining balance (i.e., your balloon payment) is due. You must pay it in full, refinance or sell the home.
Most borrowers opt for a balloon mortgage when they intend to sell their home before the final balloon payment is due. For example, homebuyers who know they’ll have to relocate for work within a few years often opt for a balloon mortgage. Some individuals also invest the money they save on mortgage payments during the first few years to maximize their return.
At the end of seven years, some homeowners are able to pay off the balance in full. Most, however, can’t afford this payment and choose to refinance with the existing lender or a new lender at that point in time. Refinancing is the simplest way of renewing the mortgage.
Many balloon loans offer the borrower a non-negotiable predetermined refinance option in case they have difficulty paying the balloon payment. Refinancing with another lender gives the borrower the chance to negotiate a new loan with a better interest rate and more appealing repayment options. It’s important to keep in mind that the rates charged when renewing with the same lender may exceed those available from a new lender.
You could also be in real trouble if your credit situation worsens between the time you take out your balloon mortgage and when you refinance. This is a spot many homeowners found themselves in after the 2008 financial crisis, as they were unable to qualify for sizeable enough loans to cover their whole balloon payment. If this happens to you, there are likely only bad options left on the table, such as foreclosure or a short sale.
The so-called “option ARM” mortgage has grown in popularity thanks to its flexible payment schedules. It’s designed for a fairly small group of high-end buyers, particularly executives whose main income is an annual bonus or others with large but variable incomes. That same flexibility has also made it among the most scrutinized loan programs because of the ease with which borrowers can qualify for a home they can’t really afford.
Before you get all excited, understand that there is no such thing as an interest-only mortgage. Eventually you'll have to pay the loan principal as well. What you're really getting is an interest-only payment method that can be combined with any type of traditional mortgage, and for that privilege you’ll pay 0.5-1% more in interest.
The option ARM, also known as a “pick-a-pay mortgage,” is a monthly adjustable rate mortgage, tied to one of the major mortgage indexes. The product allows a borrower to pay off their loan balance using one of four payment options:
- 15 year term payment (Principal and interest)
– 30 year term payment (Principal and interest)
– Interest-only payment (Usually available first 10 years)
– Minimum monthly payment (Negative amortization payment)
A mortgage is “interest only” if the scheduled monthly mortgage payment – the payment the borrower is required to make --consists of interest only. The option to pay interest only lasts for a specified period, usually 5 to 10 years. Borrowers have the right to pay more than interest if they want to.
If the borrower exercises the interest-only option every month during the interest-only period, the payment will not include any repayment of principal. The result is that the loan balance will remain unchanged.
For example, if a 30-year loan of $200,000 at 6.25% is interest only, the required payment is $1041.66. In contrast, borrowers who have the same mortgage but without an IO option, would have to pay $1231.44. This is the "fully amortizing payment" – the payment that would pay off the loan over the term if the rate stayed the same. The difference in payment of $189.78 is “principal”, which reduces the loan balance.
The option ARM definitely has the potential to keep money in your pocket, but it should be approached cautiously. A loan officer or mortgage broker may recommend the option ARM program as a way to keep your payments down, but if you don’t feel you can make the interest-only payments in the future, and eventually the much higher fully amortized payment, it’s probably best that you look for something more conventional.
Another hot mortgage product generating a lot of controversy is the reverse mortgage. A reverse mortgage loan is a financial option that lets you tap into the equity you have built in your home. These loans allow you to receive money for the things you need or want, while still living in and owning your home.
To be eligible for a reverse mortgage, both you and any co-owners of the home must be age 62 or older, and the home must be your principle residence.
The downside of a reverse mortgage is that it reduces the equity in your home. If you die and there is no other co-borrower, the reverse mortgage comes due. Your estate must repay the amount of money received, plus interest and service fees, and needless to say you won’t be passing your home down to your heirs.
Unlike traditional mortgages, there are no monthly payments with a reverse mortgage. Instead you receive funds either in a lump sum, as a line of credit, or a set monthly payment in exchange for slowly selling the equity in your home. During the loan’s term, you are still responsible for paying property taxes, required insurance premiums, and any home maintenance.
Interest accrues on the portion of the loan that is disbursed which can become very expensive very quickly since a borrower is not making any payments.
The dominant product on the market is the FHA-insured Home Equity Conversion Mortgage (HECM), available with either a fixed rate or an adjustable rate. There are two HECM products, the HECM Standard and the HECM Saver. The HECM Standard has a 2% upfront Mortgage Insurance Premium (MIP) and provides the highest loan amount, currently at $625,000. The HECM Saver has a minimal (0.01%) upfront Mortgage Insurance Premium but provides a lower loan amount.