3 types of mortgage loans for homebuyers

When it comes to getting a mortgage loan, homebuyers have fewer options than they did even a couple of years ago. In the days of the real estate boom, lenders were much more willing to float exotic loans based on risky terms, but recently they have returned to safe and sensible home financing.

Homebuyers hoping to jump into the mortgage market will find three basic types of loans, for the most part.

Fixed-interest mortgage

With a fixed-rate home loan, your interest rate remains the same for the life of the loan and the payment is split into equal monthly payments for the duration. In other words, it is amortized over the life of the loan.

The interest payments are front-loaded, however, so that during the first few years of the loan term, only a small portion of the payment pays off the principal.

Most commonly taken as a 30-year loan, fixed-rate mortgages can be shorter in duration or, more rarely, longer.

“Fixed-rate home loans can be 10 years, 15 years or 20, but most popular is the 30-year because that makes your payment the lowest,” says Floyd Walters,  owner of BWA Mortgage in La Canada Flintridge, Calif.

During the height of the real estate bubble, news broke about even longer loan terms, with some mortgages being offered for a long as 50 years. Those may have been more of an urban myth than reality, says Walters.

“To be honest, I never saw a real offering for a 50-year mortgage. I did see just a few lenders offering a 40-year mortgage,” he says.

An extremely long mortgage term offers few advantages to consumers.

“On a fully amortized 30-year fixed-rate loan at 5.25 percent for $250,000,  the payments would be $1,380 per month. Take that same loan out another 10 years to a 40-year note and the payments drop but only to $1,247 per month. You save  $133 per month but it adds 10 years to your note with a net cost of an additional $100,000 or so,” Walters says.

Adjustable-rate mortgage

Unlike a fixed-rate home loan, which sports a static interest rate over the life of the loan, the interest rate on an adjustable-rate mortgage, or ARM, changes every year.

ARMs come in various permutations. For instance, a hybrid ARM features aspects of both adjustable and fixed-rate mortgages.

“Hybrid mortgages can be anything from a three-year, five-year, seven-year, or  10-year fixed interest rate period,” says Mark Klein, president of Pacific Coast  Lending in Agoura Hills, Calif. After the fixed-rate period, the loan is amortized over the balance of the term with a rate that adjusts annually.

Conversely, a one-year ARM has no fixed-rate period. Though they are still available, they’re not widely offered, says Walters.

“It’s hard to believe there are very many people taking a one-year. I haven’t done one for years and years. It’s just not a product that feels right,” he says.

One circumstance when they might be appropriate would be in a high fixed-rate environment.

“If I could take a one-year ARM that was 1 or 2 percentage points below what  I could get as a fixed-rate mortgage, and if I could get some interest rate caps built-in, I would analyze it. If we were in a high fixed-rate environment, it might appear more attractive,” Walters says.

Unlike a plain-vanilla fixed-rate mortgage, ARMs come with more jargon than most people would care to know. But it’s vital to understand the index on which the rates are based, the margin amount, and any interest rate caps (provisions in the contract that limit rate increases).

Index — An index is a published measure of the cost of money. Lenders price home loans based on the index to which the loan will be tied. There are several different indexes lenders use to calculate the rate on ARMs. Some commonly used indexes are the one-year Treasury Constant Maturity, the London Interbank  Offered Rate, or Libor, or the 11th District Cost of Funds Index, or  COFI.

After the initial fixed-interest period, the rate will adjust based on predetermined agreements in your note.

“The lender will say, ‘We will fix your interest rate at 4 percent for the next five years. At the end of five years, we will go out and find the value of one-year Treasury bills and add a margin to that and we will fix your interest rate on the loan for a year at a time based on that (index and margin),'” says  Walters.

Margin — The margin is a set amount that will be added to the index to determine the interest rate.

Cap — The interest rate will adjust regularly, but there is a limit to the amount it can change. Typically, there will be a cap on the initial interest rate reset that is higher than all of the subsequent rate adjustments, and a cap on the amount the rate can change over the life of the loan.

“On the first adjustment with a lot of lenders, there is a 5 percent cap on the first reset and then it goes to 2 percent a year every year, with a lifetime cap of 5 percent over the starting interest rate,” says Walters.

Interest-only loan

For those buyers who need a rock-bottom payment for several years, the interest-only mortgage product, as its name implies,  allows them the option of paying only the interest for the first few years of the loan.

“You can pay principal if you wish; interest-only is an option,” says  Walters.

Interest-only loans are structured like an adjustable-rate mortgage.

“The most common one is the five-year fixed 30-year loan,” says Klein. “The payment and interest rate are fixed for five years and the payment could be based on only the interest payment, so you’re not paying down the principal.  When it resets your payments can go up pretty significantly, even if the  interest rate doesn’t change that much.”

An interest-only loan may be appropriate for homebuyers who believe their income will increase in the coming years — for instance, young families or a  professional just starting out at the bottom of a potentially lucrative field such as law or medicine.

“Who they are not good for is someone who is stretching every dollar to get into a house and whose income is going to be relatively flat,” says Walters.

No matter what kind of loan gets you into a home, do your homework beforehand and make sure there are no details about the mortgage loan you don’t understand.