Whether you are looking for a first mortgage, adding a second mortgage or trying to refinance an existing mortgage, it is helpful to understand more about general loan classifications.
Mortgage loans are categorized as either fixed rate mortgages (FRM), adjustable rate mortgages (ARM) or some combination (hybrid) of the two. This classification is based on the type of interest rate structure governing the loan. The most common mortgage terms are 30 or 15 year loans (also, 25, 20 and 10). Generally, a short term loan will have less interest and higher payments - a long term loan, more interest and lower payments. A 15 year mortgage may have less than half the interest costs of a 30 year mortgage.
Characteristics of a Fixed Rate Mortgage:
The interest rate is fixed for the life of the loan (whether interest rates go up or down)
Payments generally stay the same each month
Characteristics of an Adjustable Rate Mortgage:
The interest rate is adjusted periodically by adding a margin to an index specified by the mortgage (a 1-year ARM adjusts annually)
Payments generally fluctuate along with the interest adjustment
ARM's have limits on the amount of interest adjustment that can be made in given periods and across the life of the loan
Characteristics of a Hybrid Loan:
The interest rate follows some set plan for adjustment, using a combination of fixed and adjusting interest rates
Options are designed to meet a wider variety of needs
Qualifying standards are often more liberal than traditional loans
Mortgage loans are also categorized as government loans or conventional loans. Government loans are FHA, VA and RHS loans; all other loans are conventional.
FHA Loan The Federal Housing Administration (FHA) does not make the loans; it provides mortgage insurance which protects the lender. Although FHA loans have statutory limits, the qualifications are generally more liberal than those for conventional loans. They have lower down payment requirements (only 3 percent down), lower monthly insurance premiums, and often, lower closing costs which can also be financed. FHA loans are intended to aid eligible families with low-to-moderate incomes who do not qualify for conventional loans.
VA Loan Like the FHA loans, VA loans are only guaranteed by the U.S. Department of Veteran Affairs; lenders make the loans to eligible veterans for the purchase, construction, or energy-saving improvement (approved by the lender and VA) of a home. VA loans also have easier eligibility requirements than conventional loans, often lower closing costs, and more liberal terms (usually no down payment is required) including negotiable interest rates. If you are eligible, the VA will issue a certificate of eligibility that you take to the lender when making application for your loan. Lenders generally place a maximum limit on VA loans.
RHS Loan RHS loans, guaranteed by Rural Housing Services under U.S. Department of Agriculture, much like the other government loans, also contain easier terms (such as no down payment and low closing costs.) RHS loans are available to rural residents with low-to-moderate incomes that are without adequate housing and unable to obtain credit elsewhere. RHS loans are for construction or repair of new or existing homes.
Conventional Loans Conventional loans are classified as conforming or non-conforming.
Conforming loans Loans that adhere to the guidelines set forth by Fannie Mae (from FNMA: Federal National Mortgage Association) and Freddie Mac (from FHLMC: Federal Home Lone Mortgage Corp ) , two corporations that purchase, package and sell loans that meet their conditions as securities to investors. These are referred to as “A” paper loans. Conforming loans must meet certain guidelines regarding down payment, loan limits, borrower qualifying criteria and appropriate properties.
Non-conforming Loans Loans that fall into “B, C or D” paper profiles are the non-conforming loans. They are often offered to high credit-risk borrowers with a detrimental credit history by portfolio lenders. Portfolio lenders don't intend to sell their loans so they can be more liberal about their borrowers' eligibility requirements. However, these loans, often called jumbo loans, generally have a higher interest rate than conforming loans.
With the variety of loan possibilities, it is important to consider your needs in conjunction with the options available before making your loan choices. Your decision is often influenced by the amount of payment you can afford and how long you plan on staying in your house. Unless your intention is to stay long term, you may want to consider an option other than a fixed rate mortgage, such as an ARM or Hybrid loan. Some of these options allow for lower interest rates in the earlier stages, with options to convert or phase into a fixed rate over time.
Some of the more common loans you may want to consider are:
Second Mortgage (or home equity loan) A second mortgage is a loan secured by the equity in your property that already has a first mortgage. Generally, considering both loans together– the first and the second, a lender will not loan more than 75 to 80 percent of the home's appraised value. Compared to the first mortgage, the second mortgage will often have higher interest rates and a shorter life term.
The ability to borrow on the equity of your home for various reasons (home improvements, credit consolidation, other current financial needs, college funds, etc) is a big advantage to a home owner. However, because a second mortgage lender is at a greater risk, taking second place to the first mortgage lender, the terms are less flexible. As with the first mortgage, you will be required to obtain an appraisal , verify information such as income, and show credit in good standing.
Home Equity Line of Credit A home equity line of credit (HELOC) is similar to a home equity loan, except that the funding can happen over a period of time. An appraisal will be required to determine the amount of the equity-based line of credit. This credit line is an approved sum against which the borrower may draw (or pay down and even draw back up) as desired, up to that pre-determined amount, for a specific duration of time (5, 10, even 20 years). Most often the interest rate will fluctuate month by month during the funding period. Generally you will make monthly interest-only payments until the loan is completely funded. Once that pre-set funding period is over, the credit line will convert to a second mortgage loan, and payments for both the principle and interest will begin. Many of the loan costs and fees applicable to the first mortgage are required for the HELOC as well.
“Carry Back” Loan When a borrower does not have sufficient down payment to qualify for the first mortgage (generally at least 20% down is required), a seller may offer to “carry back a second mortgage” for the difference. Although the interest rate on the seller's loan is generally higher than the first mortgage, the carry back loan provides a way for the buyer to finance the portion not included in the first mortgage.
Two-Step Mortgage A Two-Step mortgage begins with a fixed rate (usually lower than a fixed rate mortgage would be). There is one adjustment after a certain time (usually 5 or 7 years) to a new fixed rate - set at the current market rate at the time of the change. This adjustment has a cap to ensure that it will never be more than 6 percentage points higher than your original rate.
Convertible ARMs Much like a two-step mortgage, some ARMs provide an option to later convert to a fixed rate (based on the current market rate, at the time of conversion, but generally a little higher). The option may be easily exercised at certain specified times (generally during the first five years) for a nominal fee.
Fixed-period ARMs Contrary to convertible ARMs, fixed-period ARMs begin with a fixed rate that extends for a specified “fixed” period. At the end of that period, the interest rate (with certain caps) adjusts annually. The interest rates are lower than a standard 30-year mortgage as the lenders risk is lower since they are not locked in so long.
Balloon Loans A balloon loan is a short-term fixed-rate loan with low, fixed payments for the short term period, but requiring a single large payoff, due at the end of the term (5, 7 or 10 years.) This can be advantageous if you plan on moving or selling within a few years. Even if you stay beyond the end of the short term of your balloon loan, you may be able to reconsider financing options at that time.
Piggyback Loans Generally a first mortgage will only finance 80 percent of the value of your property, requiring the borrower to pay a down payment for the difference. If your down payment is short, a piggyback loan serves like a second mortgage to make up the difference. The two loans are approved at the same time.
Zero Down Mortgage Qualification for a zero down mortgage is based on your ability to make your monthly payments. However, the loan will be larger than a typical mortgage and the interest rates higher. Not all lenders will make zero down mortgages; you may have to shop around. However, FHA loans have extremely small down payment requirements, coming close to a zero down mortgage.
Bridge Loans Bridge loans cover the time period between when a buyer closes on a new mortgage and finalizes the sale of his previous home, at which time the bridge loan is paid off. This time period of owning both houses creates several problems for the buyer. Offers made with a contingency clause (contingent on the sale of the current house) are often turned down. Also, the buyer would be obligated on two mortgages, causing financial overburden repercussions.
Bridge loans are usually 1 year loans, structured to pay off the first house, provide for six months interest on the bridge loan and closing costs, and contribute toward the down payment on the new house. The bridge loan is paid off when the first house sells. If the house does not sell within the first six months, the buyer will make interest-only payments on the bridge loan.
Buydown Options A buydown loans is a fixed rate mortgage that allows the borrower to pay points to lower the interest rate. The option may include a reduction for the life of the loan or only for a specified few years at the beginning of the loan. Some options will even finance the discount points. A buydown option lowers the payment amount and opens the possibility of qualifying for a higher priced home.
Reverse Mortgages A reverse mortgage is designed to help elderly home owners benefit from their equity without having to sell their house or make payments. The loan is funded through a lump sum payment, monthly payments or a line-of-credit. The money received from the loan is not taxable nor is it considered in determining Social Security or Medicare benefits. The loan does not have to be paid until the homeowner sells the property, moves or passes away. The elderly home owner is secure in the home even if the loan term ends or the loan grows beyond the value of the property.