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Types of Mortgages are Multiplying like Rabbits
National competition has created a dazzling array of rates and terms. Your job is not only to get the best rate you can given your situation, but also to get a loan that matches your needs. The following will help you do that. Look at each of the terms below and decide whether or not it is important to you. Check off the ones you would like to get. Once you have that done, you can shop for the best rate available in a mortgage that includes the terms you want.
The most important difference between mortgage types is the amount you “put down” from your own money towards the purchase of the property. This is the single most important requirement for any mortgage. The more you can put down the better the rate. The reason for this, is that lenders know that anyone who has a lot of their own money in a house is unlikely to default.
Conventional Mortgage
Normally you should put as much down as you can. Putting down at least 20% of the purchase price gets you a “conventional mortgage.” Generally conventional mortgages have the best rates.
Putting down more than 20% might have some effect on your rate, and it might not, but it will certainly lower your monthly payments. If you think you can invest the extra money at a rate higher than you are paying on your mortgage, you might prefer to do that with the money.
Low down payment mortgages
Lenders who write mortgages on properties where the borrower is making a down payment of less than 20% almost always require that you purchase “mortgage insurance.” There are two types, government and so-called Private Mortgage Insurance (PMI). The Federal Housing Administration (FHA) provides most of the insurance. Buying this insurance will usually raise your interest rate by half a percentage point or more. On a $200,000 mortgage that could be nearly $800 a year for as long as you hold the mortgage.
The insurance will reimburse the lender if you default on the loan and the lender is stuck, but if there was any problem with the original application for the mortgage, the insurer may refuse to reimburse the lender.
In addition to paying for mortgage insurance, borrowers who put less than 20% down almost always end up paying higher interest rates. So you can save a fair amount of money simply by putting 20% down. But very few people do that unless they are selling a home and investing their profits in another property.
Another problem for borrowers with no down payment loans is that if property values go down, borrowers are more likely to give up on the house and allow the lender to foreclose thinking that will be the end of it. It isn’t. The lender will come after you for the difference between the mortgage balance and what they were able to get for the house. You are still legally obligated.
No down payment mortgages
Many lenders today are issuing mortgage loans with no down payment required. In 2005, 43% of all first time buyers in the United States bought a home with no down payment according to the National Association of Realtors.
Since the borrower has none of their own money in these homes, lenders generally not only require mortgage insurance but they will also charge higher interest. Even a half point will increase your monthly payment by about $30. If your mortgage is $200,000, double that number.
Interest-only mortgages
Normal mortgage loans require at least a small portion of the payment to be applied to principle every month. Thus as each payment is made, the principle balance is lowered, slightly at first but by larger and larger amounts over time.
Let’s say your payment is $1,200 every month on a $200,000 mortgage. Maybe $100 of that goes intro reducing the principle in the first month. If so, in the next month the interest will be calculated on $190,900, and a little more of your $1,200 payment will go into principle. Before long, a third of every payment is being applied to reduction of principle. There are many web sites that will show you a complete amortization table, month by month.
With interest only loans, this does not happen, at least not for a while-- typically the first five years. The monthly payment in our example above would be $1,100, and all of it would go to interest. However, after some period of time (often five years) the payment would go up, say to $1,300, and $200 of the new amount would go into reducing the principle.
People use these mortgages to lower their monthly payment, allowing them to qualify for a bigger mortgage. They hope that in five years, when the payment jumps, they will be earning more money. However, if the borrower cannot pay more when the rate goes up, there could be a big problem.
As with no down payment loans, risk of foreclosure is higher with these loans, and lenders charge higher interest rates. You should make sure you check just how much higher the interest rate is with an interest only loan as opposed to a no down payment loan.
One other problem with interest only loans, is that if house prices go down, you are more likely to find yourself owing more than the house is worth, and you will be tempted to “walk” away from the house. However, you will still be held liable for any difference between the balance of the mortgage and the amount the house is sold for.
Negative Amortization or “payment option” mortgages
These are a specific kind of loan in which the payments you are required to pay in the first year or more are not enough to cover the interest due. These loans go by more than one name, but no matter what they are called, they have one thing in common: The minimum monthly payment is not enough to cover the interest due, so unless you pay more than your bill requires (and how many of us do that?), the principle will go UP instead of down. In effect, you will be paying interest on unpaid interest.
The most common purpose of these loans is to lower the monthly payment so people can buy houses with larger mortgages than they could qualify for under other mortgage rules. Initially you pay less, so your “ratios” (your total obligations as percent of income) look better. But before long the payment leaps up, and if you cannot make the new minimums, your secured asset (like your home) will be repossessed.
Most people think these are a bad idea, and I agree, Unless you know for sure that your income is going to grow substantially relatively soon, you will probably be digging yourself a hole out of which you cannot climb!
Second Mortgages
If you already have a mortgage on your house but you want to borrow money for repairs or an addition or even to buy a car or for some other purchase, many banks and mortgage companies will be more than happy to give you a “home equity” loan or line of credit if you have enough equity in your home.
For example, your house might be worth $300,000 today but the balance remaining on your mortgage might be only $150,000. Almost any bank would give you some sort of second mortgage (that’s what home equity loans are), and some sub-prime lenders would be willing to give you a loan that would bring your total mortgages up to 125% of the value of your house (in our example above, the owner could borrow another $175,000).
Since, if you default, the holder of the first mortgage has to be paid off first (before the holder of the second mortgage gets any money) the rate on the second mortgage will generally be much higher than the first mortgage rate, unless the interest is variable, in which case it could be lower, at least to start. Some home equity loans change rates every month. Rates are pegged to a published index, like the London Interbank Offered Rate (LIBOR) -- the most widely used benchmark or reference rate for short term interest rates. (LIBOR is the rate of interest at which banks can borrow funds from other banks, in marketable size, in the London interbank market.) Index-pegged rates can go up by many points in just a few months as short term rates are rather volatile.
The amount of equity you have left in your home after the two mortgages are paid off is also a determining factor in how much interest you will pay. Borrow as little as you can, and always remember these payments are on top of whatever it is you are paying for your first mortgage.
When you look at a second mortgage, you should also think about refinancing your house with a larger first mortgage in order to take out money. A first mortgage will probably have a lower interest rate. However, if you set it up for a long period, like 30 years, and do not pay it down sooner, the total interest you pay will be much higher in dollar terms since second mortgages generally require shorter pay back periods.
Reverse Mortgages
This type of mortgage has been around for about 25 years or so, but it recently has become much more common under federal guarantees and sponsorship.
In a “normal” mortgage you get all the money up front and pay it back slowly over time. In this type of loan, while you might get something up front, you usually get most of your money over time (usually a monthly check) and pay it back in a lump sum when you sell the house or die.
This type of loan is designed to help older people (you must be over 62 in most cases) to take money out of their homes for living or medical expenses. For example, someone who is 70 years old and needs more money to be able to stay in their house might apply for a reverse mortgage. Let’s say he gets $40,000 up front to pay off the old mortgage and to pay all fees associated with the reverse mortgage (insurance fees, brokerage fees etc. -- they can really mount up) and then takes $1,000 a month.
At the end of the first year his mortgage balance will be $40,000 plus $12,000 (these are both “principal”) plus interest on the principal. This whole amount becomes the base principal for the next year and the calculation goes on like that from year to year.
Three things stop this process:
- Reaching the maximum balance for the loan, which is known in advance. (Federal regulations determine maximums for every area. Generally, in high priced areas loan limits are now as high as $362,790. In rural and non- metropolitan areas, you can borrow up to $220,160.)
Usually it takes many years to hit the limit. If you get there, no more payments are made but neither is their any need to pay off the loan. You are not thrown out of your house. - The sale of the house. If you sell the house, the mortgage balance must be paid off, just as it is with a conventional mortgage. That part is the same.
- The death of the borrower. When this happens the mortgage comes due. If the family wants to keep the property they have to refinance the house with a conventional mortgage and pay off the balance.
Remember though, as long as the borrower is alive they do not have to pay off the loan or sell your house.
Click Here to compare Reverse Mortgages with Regular Mortgage in more detail.
Bridge Loans
These are loans secured by a mortgage on your property that are intended for short term use. Often they are used by people who have bought a new house and not yet sold their present home. The loan will give them the cash necessary to close on the new house. It may even be enough to pay off the existing mortgage on the old house. Sometimes there are no payments due until the old house is sold, when the whole bridge loan must be paid off.
The major risk of bridge loans is that your old house does not sell and you are stuck with payments far beyond your means. It can be a mess.
Balloon Mortgages
Although they may have legitimate use in a few selected situations, these are the tool often used by scam artists. They come in many forms, but the basic principle is that you pay very little for some period of time, and then you have to make a huge payment, usually paying off the whole mortgage. They usually have every high interest rates because they are risky. People use these when they think that they cannot get a good mortgage now, but something is going to change in their lives soon, and they will then be able to cover the balloon payment with a more conventional mortgage. It’s like working with dynamite. If things go well, you’ll be fine. If not, your life could be blown up.