Once you have decided in favor of buying your home, the next decision one must make is where to obtain the mortgage, and the type of mortgage best suited for their situation.

With the ever increasing complexity and variety in mortgage options, it is easy for one to be overwhelmed. The following article should provide

a brief overview of the common types of mortgages, property and home loans, and how each of them works in the long run.

Types of Loans

Fixed Rate

Historically Fixed rate mortgages are the most common type of mortgages issued. The term for these mortgages typically runs 30 years. Fixed rate mortgages offer constant monthly payments, at a reasonable level, due to their extended length. Consumers are content knowing that the payment will be the same regardless of variations in ‘key rates’ or other outside events. In times of low interest rates, these mortgages are almost ubiquitous, as the payment will be very low, and consumers are eager to lock in this low rate.

A decision many will ponder when approaching a fixed rate mortgage is the term. Should one go with a 15 year or 30 year? The argument is often made to show how much interest will be saved if one elects to go with a 15 year, however, is it the best choice?

Overall, most people would be best choosing the 30 year mortgage. This is simply due to the flexibility it would provide. With a 15 year mortgage, the interest is much less over the length of the mortgage because the monthly payments are significantly higher. Signing onto this term is forcing the borrower to meet these higher payments each month. On the other hand, if one were to elect the 30 year mortgage, there is nothing stopping them from paying more than their ‘assigned’ payment each month, and paying down the mortgage just as fast. In this scenario, the borrower could make these high payments and reap the benefits of a 15 year mortgage, but is not under the obligation to do so.

Adjustable Rate (ARM)

The next most popular type of mortgage is the adjustable rate mortgage, often referred to as an ARM. With an ARM, the interest rate and the corresponding monthly payment change in sync with changes in the overall market interest rates. These changes could be tied to various indexes; however, the most common is the current yield on 1 year US Treasury bonds.

ARMs usually begin with a fixed-rate period, where the rate offered is below the rate offered on traditional fixed-rate mortgages. This low rate, often called a ‘teaser rate’ can attract many borrowers looking short term for the lowest monthly payment. After this fixed rate period, or

‘honeymoon period’, the rate adjusts in correlation to the index the rate is tied to. The most common length of honeymoon period is currently 5 years, with rate adjustments coming every 1 year after. This would be described as a 5/1 ARM.

However, ARMs do attract negative press, and often with good reason. If the interest rates rise dramatically, the borrower could be left with payments double (or more) their original payments. This sharp increase is difficult to budget for, and has lead to many foreclosures in the recent years. If one was to pursue an ARM, they should be fully aware of the possible increases, and be prepared to come up with additional funds each month.

Interest Only

Interest only mortgages, when used for residential lending, are typically bi-products of adjustable rate mortgages. Many of the facts of the above ARMs hold, however during the fixed-rate period the borrower is only required to pay the interest on the loan. Once this period is up, the rate adjusts to the market rate, and the amortization (pay down) is accelerated to make up for the period of no principal being paid down. These loans, while most common in commercial settings, are sometimes used by high income individuals with significant variations in their monthly incomes (commission-based).

Subprime

Subprime loans are typically issued to borrowers who have recent or ongoing credit issues. Although the limit varies, many use a credit score of below 620 as the qualifying level at which a loan will be “subprime”.

Using the low credit score of the borrower as an indication of risk to the lender, the rates will be higher on subprime mortgages than the aforementioned options. In addition, while traditional mortgages tend to be very similar in terms and rates across lenders, subprime loans can vary widely depending on the specific credit situation of the borrower in question. For this reason, consumers looking into subprime loans for real estate purchases would be even more prudent to attain quotes from various lenders, as the payments and terms could be drastically different.