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MORTGAGE LOAN TYPES

All mortgage programs can be divided into categories in two different ways. Firstly, conventional and government loans. Secondly, all the various mortgage programs may be classified as fixed rate loans, adjustable rate loans and their combinations.

Conventional and Government Loans

Any mortgage loan other than an FHA, VA or an RHS loan is conventional one.

FHA Loans

The Federal Housing Administration (FHA), which is part of the U.S. Dept. of Housing and Urban Development (HUD), administers various mortgage loan programs. FHA loans have lower down payment requirements and are easier to qualify than conventional loans. FHA loans cannot exceed the statutory limit. Click here for more info on FHA Loans.

VA loans

VA loans are guaranteed by U.S. Dept. of Veterans Affairs. The guaranty allows veterans and service persons to obtain home loans with favorable loan terms, usually without a down payment. In addition, it is easier to qualify for a VA loan than a conventional loan. Lenders generally limit the maximum VA loan to $250,000. The U.S. Department of Veterans Affairs does not make loans, it guarantees loans made by lenders. VA determines your eligibility and, if you are qualified, VA will issue you a certificate of eligibility to be used in applying for a VA loan. Click here for more info on VA Loans.

VA-guaranteed loans are obtained by making application to private lending institutions.

RHS Loan Programs

The Rural Housing Service (RHS) of the U.S. Dept. of Agriculture guarantees loans for rural residents with minimal closing costs and no down payment.

Ginnie Mae, which is part of HUD, guarantees securities backed by pools of mortgage loans insured by these three federal agencies - FHA, VA, or RHS. Securities are sold through financial institutions that trade government securities.

State and Local Housing Programs

Many states, counties and cities provide low to moderate housing finance programs, down payment assistance programs, or programs tailored specifically for a first time buyer. These programs are typically more lenient on the qualification guidelines and often designed with lower up front fees. Also, there are often loan assistance programs offered at the local or state level such as MCC (Mortgage Credit Certificate), which allows you a tax credit for part of your interest payment. Most of these programs are fixed rate mortgages and have interest rates lower than the current market.

Conforming Loans

Conventional loans may be conforming and non-conforming. Conforming loans have terms and conditions that follow the guidelines set forth by Fannie Mae and Freddie Mac. These two stockholder-owned corporations purchase mortgage loans complying with the guidelines from mortgage lending institutions, packages the mortgages into securities and sell the securities to investors. By doing so, Fannie Mae and Freddie Mac, like Ginnie Mae, provide a continuous flow of affordable funds for home financing that results in the availability of mortgage credit for Americans.

Fannie Mae and Freddie Mac guidelines establish the maximum loan amount, borrower credit and income requirements, down payment, and suitable properties. Fannie Mae and Freddie Mac announce new loan limits every year.

The 2006 conforming loan limits for first mortgages are:

The maximum loan amount is 50 percent higher in Alaska, Guam, Hawaii and the Virgin Islands. Properties with five or more units are considered commercial properties and are handled under different rules.

The 2006 loan limit for second mortgages is $208,500 (in Alaska, Guam, Hawaii, and the Virgin Islands, the maximum second loan amount is $312,750). The sum of the original loan amounts of the first and second mortgages cannot exceed $417,000 (or $625,500 in Alaska, Guam, Hawaii, and the Virgin Islands).

Jumbo Loans

Loans above the maximum loan amount established by Fannie Mae and Freddie Mac are known as 'jumbo' loans. Because jumbo loans are bought and sold on a much smaller scale, they often have a little higher interest rate than conforming, but the spread between the two varies with the economy.

B/C Loans

Loans that do not meet the borrower credit requirements of Fannie Mae and Freddie Mac are called 'B', 'C' and 'D' paper loans vs. 'A' paper conforming loans. B/C loans are offered to borrowers that may have recently filed for bankruptcy, foreclosure, or have had late payments on their credit reports. Their purpose is to offer temporary financing (ie. "band aid loan") to these applicants until they can qualify for conforming "A" financing. The interest rates and programs vary, based upon many factors of the borrower's financial situation and credit history.

Fixed Rate Mortgages

With fixed rate mortgage (FRM) loans, the interest rate and your mortgage monthly payments remain fixed for the period of the loan. Fixed-rate mortgages are available for 10, 15, 20, 30, 40 years and 50 years. Generally, the shorter the term of a loan, the lower the interest rate you could get.

The most popular mortgage terms are 30 and 15 years. With the traditional 30-year fixed rate mortgage your monthly payments are lower than they would be on a shorter term loan. But if you can afford higher monthly payments, a 15-year fixed-rate mortgage allows you to repay your loan twice as fast and save more than half the total interest costs of a 30-year loan.

The payments on fixed rate, fully amortizing loans are calculated so that at the end of the term, the mortgage loan is paid in full. During the early amortization period, a large percentage of the monthly payment is used for paying the interest.

With a bi-weekly mortgage plan, you pay half of the monthly mortgage payment every two weeks. It allows you to repay the loan much faster. For example, a 30 year loan can be paid off within 18 to 19 years.

Balloon Loans

Balloon loans are short-term fixed rate loans that have fixed monthly payments based usually upon a 30-year, 40 year, or 50 year fully amortizing schedule and a lump sum payment at the end of its term. They usually have terms of 2, 3 or 5 years.

The advantage of this type of loan is that the interest rate on balloon loans is generally lower than 30- and 15-year mortgages, resulting in lower monthly payments. The disadvantage is that at the end of the term, you will have to come up with a lump sum to pay off your lender, either through a refinance or from your own savings.

Balloon loans with refinancing options allow borrowers to convert the mortgage at the end of the balloon period to a fixed rate loan -- based upon the outstanding principal balance -- if certain conditions are met. If you refinance the loan at maturity you need not be requalified, nor the property reapproved. The interest rate on the new loan is a current rate at the time of conversion. There might be a minimal processing fee to obtain the new loan. The most popular terms are 5/25 Balloon, and 7/23 Balloon.

Adjustable Rate Mortgages

Variable or adjustable rate loans are loans whose interest rate -- and therefore, monthly payments -- fluctuate over the period of the loan. With this type of mortgage, periodic adjustments are made to the interest rate, based on changes in a defined index. The index for your particular loan is established at the time of application.

Well known ARM indexes include:

• Constant Maturity Treasury (CMT)
• Treasury Bill (T-Bill)
• 12-Month Treasury Average (MTA or MAT)
• Certificate of Deposit Index (CODI)
• 11th District Cost of Funds Index (COFI)
• Cost of Savings Index (COSI)
• London Inter-Bank Offering Rates (LIBOR)
• Certificates of Deposit (CD) Indexes
• Bank Prime Loan (Prime Rate)
• Fannie Mae's Required Net Yield (RNY)
• National Average Contract Mortgage Rate

New interest rate = index + margin

The margin is a fixed amount of percentage points added to the index, to compute the new interest rate. The result will then be rounded to the nearest one-eighth of a percent.

Example:

If the index is 5.3% and the margin is 2.5%,
then the new interest rate is 5.3% + 2.5% = 7.8%.
The nearest 1/8% to 0.8% is 6/8%, or 0.75%.
The final result will be 7.75%.

The margins remain fixed for the term of the loan and are not impacted by the financial markets and movement of interest rates. Lenders use a variety of margins depending upon the loan program and adjustment periods.

Most ARMs have an interest rate cap to protect you from enormous increases in monthly payments. A lifetime cap limits the interest rate increase over the life of the loan. A periodic or adjustment cap limits how much your interest rate can rise at one time.

Examples:

1. The initial interest rate is 4.5%, the index is 7%, and the margin is 3%,
   then the new interest rate = 7% + 3% = 10%.
   If the lifetime cap is 5% then
   the actual new interest rate will be 4.5% + 5% = 9.5%.
    
2. The initial interest rate is 6%, the index is 5%, and the margin is 3%,
   then the new interest rate = 5% + 3% = 8%.
   If the periodic cap is 1% then
   the actual new interest rate will be 6% + 1% = 7%.

Your mortgage disclosure will tell you the exact index to be used, whether the weekly or monthly value applies, the lead time for your index, the margin, and any caps.

Interest-Only Mortgage Loans

The loan product commonly called 'Interest-Only Mortgage' is an interest-only payment option which is offered on fixed rate ( FRM ) or adjustable rate ( ARM ) mortgages or on option ARMs. The option to pay 'interest-only' lets you pay only the interest portion of your monthly payment for a fixed period (3, 5, 7 or 10 years). At the end of that period your loan becomes fully amortized, thus resulting in greatly increased monthly payments. Your new payment will be larger than it would have been if it had been fully amortizing from the beginning. The longer the interest-only period, the larger the new payment will be when the interest-only period ends.

Example:

If a 30-year fixed rate loan of $350,000 at 7% has interest-only payments for 5 years, the payment during the interest-only period is $2,625.00. Starting in month 61, the payment is $3,180.51. The fully amortizing payment (the payment that, if maintained over the term of the loan, will pay it off completely) would be $2,993.86. So in order to reduce your payment by $368.86 for the first 5 years, you pay an additional $186.65 for the next 25 years.

Interest-only payment plans are for borrowers who expect to earn a lot more in a few years and want to maximize their buying power now or who will invest the difference between an interest-only and an amortizing mortgage payments, and who are confident that these investments will make money.

Advantages

• During the interest-only term your monthly payments are as low as they can possibly get
• You can qualify for a larger loan amount, maybe even a larger home
• During the interest-only term, you won't pay out cash to build equity
• Make investments with payment difference to potentially build your net worth
• The entire monthly payment qualifies as tax-deductible interest during the interest-only period

ARMs with Interest-Only Payments

Interest-only payment options are typically offered on adjustable rate mortgages.

Payments made during the initial interest-only period are based on the interest rate and loan balance and are applied towards interest only (they will not reduce the principle balance of your loan). Please note that the initial interest rate for the loan is established by your lender based on market conditions and may be lower than, or higher than the rate that is based on the index used to make rate adjustments. 

After the initial interest-only period, the loan converts to a traditional ARM; monthly payments are based on the interest rate, loan balance and remaining loan term, and are applied towards principle and interest. The interest rate will be adjusted periodically based on the index rate plus a margin (your rate will be equal to the index rate plus the margin, rounded to the nearest one-eighth of one percentage point, unless your interest rate cap limits the amount of change in the interest rate).

30-Year Fixed Loan with Interest-Only Payments

This loan program will give you the advantage of having a lower monthly payment for 10 or 15 years, and the security of having the same interest rate for the 30 year period. In addition, if you choose to send in more than the interest-only payment, the loan payment will recalculate the following month and you will then have a lower payment from that point on for the remainder of the interest-only period. The downside is, if you continue to make only the interest-only payment for the 10 or 15 year period, then after the interest-only period is over, the loan payment will now jump quite a bit. You would then have a 15- or a 20-year "principle and interest" payment for the remainder of the 30-year period.

Negatively Amortizing Loans

Some types of ARMs (for example, option ARM loans) offer payment caps rather than interest rate caps, which limit the amount the monthly payment can increase. If a loan has payment cap but has no periodic interest rate cap, then the loan may become negatively amortized: if the interest rates rise to the point that the monthly mortgage payment does not cover the interest due, any unpaid interest will get added to the loan balance, so the loan balance increases. However, you always have the option to pay the minimum monthly payment, or the fully amortized amount due.

Example:

Your loan has a payment cap of 7.5%. If your payment is $1,000 per month and interest rates rise, your new payment would normally be $1,200/mo (for example). But your capped payment is only $1,075. The other $125 gets added to your loan balance, to be paid off over time, unless of course you decide to pay that additional amount now.

The advantage of negatively amortizing loans is that you can control cash flow (relatively stable payment), take advantage of low interest rates relative to the market at any given time, and pay back the money borrowed today at a depreciated value years from now (because of natural inflation). This makes such loans a great tool for homeowners as long as you understand the mechanics of what's going on.

With most ARMs, the interest rate can adjust every month, every three or six months, once a year, every three years, or every five years. The interest rate on negatively amortized loans can adjust monthly. A loan with an adjustment period of 6 months is called a 6-month ARM, with an adjustment period of 1 year is called a 1-year ARM, and so on.

Most ARMs offer an initial interest rate much lower than the fully indexed rate (index plus margin) during the initial period of the loan, which could be one month or a year or more. It is also known as a "teaser rate."

All ARMs are available with 30-year terms, and some with 40- or 50-year terms.

Adjustable rate mortgages generally have a lower initial interest rate than fixed rate loans.

Option ARM Loans

One of the most creative products that doesn't require a set payment each month is the option ARM. After the first payment, you get four payment options to choose from each month: your lender sends you a monthly statement offering 1) a minimum payment, 2) an interest-only payment, 3) a 30-year amortized payment, or 4) a 15-year amortized payment.

Combined (Hybrid) Loans

Hybrid loans, a combination of fixed and ARM loans, come in different varieties, oulined below.

Fixed-period ARMs

With fixed-period ARMs, homeowners can enjoy from three to ten years of fixed payments before the initial interest rate change. At the end of the fixed period, the interest rate will adjust annually. Fixed-period ARMs -- 30/3/1, 30/5/1, 30/7/1 and 30/10/1 -- are generally tied to the one-year Treasury securities index. ARMs with an initial fixed period have a lifetime cap, adjustment caps and often, a first adjustment cap. It limits the interest rate you will pay the first time your rate is adjusted. First adjustment caps vary with type of loan program.

The advantage of these loans is that the interest rate is lower than for a 30-year fixed (the lender is not locked in for as long, so their risk is lower and they can charge less) but you still get the advantage of a fixed rate for a period of time.

Two-Step Mortgage

Two-Step mortgages have a fixed rate for a certain time, most often 5 or 7 years, and then the interest rate changes to a current market rate. After that adjustment, the mortgage maintains the new fixed rate for the remaining 25 or 23 years (for a total of 30 years).

Convertible ARMs

Some ARMs come with an option to convert them to a fixed-rate mortgage at designated times (usually during the first five years, on the adjustment date), if you see interest rates starting to rise. The new rate is established at the current market rate for fixed-rate mortgages.

The conversion is typically done for a nominal fee and requires almost no paperwork. The disadvantage is that the conversion interest rate is typically a little higher than the market rate at that time.

The other kind of convertible mortgage is a fixed rate loan with rate reduction option. If rates had dropped since the time of closing it allows you, under some prescribed conditions, for a small conversion fee to adjust your mortgage to going market rate. Generally the interest rate or discount points may be a little higher for a convertible loan.

Graduated Payment Mortgages (GPMs)

Graduated payment mortgages have payments that start low and gradually increase at predetermined times. Lower initial payments allow you to qualify for a larger loan amount. The monthly payments will eventually be higher in order to catch up from the lower payments. In fact, your loan will be negatively amortizing during the early years of the loan, then pay off the principal at an accelerated pace through the later years.

Lenders offer different GPM payment plans, which vary in the rate of payment increases and the number of years over which the payments will increase. The greater the rate of increase or the longer the period of increase, the lower the mortgage payments in the early years.

Buydown Mortgage

A temporary buydown is the type of loan with an initially discounted interest rate which gradually increases to an agreed-upon fixed rate usually within one to three years. An initially discounted rate allows you to qualify for more house with the same income and gives you the advantage of lower initial monthly payments for the first years of the loan, when extra money may be needed for furnishings or home improvements. To reduce your monthly payments during the first few years of a mortgage you make an initial lump sum payment to the lender. If you do not have the cash to pay for the buydown, the lender can pay this fee if you agree on a little higher interest rate.

A very popular buydown is the 2-1 buydown.

Example:

If the interest rate on the note is 8% with a 2-1 buydown mortgage your initial discounted rate is 6% and you would have 6% interest rate for the first year, 7% for the second year, and 8% afterwards. You will need to prepay the difference in payments between the 6% and 8% rates the first year, and between the 7% and 8% rates the second year.

3-2-1 and 1-0 buydowns are also available, though less common. Compressed Buydown, works the same way, but with the interest rate changing every six months instead of on a yearly basis.

The lower rate may apply for the full duration of the loan or for just the first few years. A buydown may be used to qualify a borrower who would otherwise not qualify. This is because a buydown results in lower payments which are easier to qualify for.

With a variety of different loan programs available, it is important to choose the type of loan that will best suit your needs

The right type of mortgage chiefly depends on how long you plan on staying in the house and the amount of monthly payment you can comfortably afford.

If you don't plan to stay in your house for at least 5 to 7 years, it will be reasonable to consider an Adjustable Rate Mortgage, Balloon Mortgage or Two-Step Mortgage. ARMs traditionally offer lower interest rates than fixed-rate loans, during the early years of the loan. A Two-Step Mortgage will give you a lower interest rate than a 30-year mortgage for the first five or seven years. A Balloon Mortgage offers lower interest rates for shorter-term financing, usually 5 or 7 years. Because of a lower interest rate it is easy to qualify for these type of mortgages. However, don't accept the ARM unless you can afford the maximum possible monthly payment.

Generally, you can start to consider 15- or 30-year fixed rate mortgages if you plan to stay in your home for more than 7 years.