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Different Types of Mortgage Loan Options

By Veronica Nguyen · Feb 3, 2015 · Mortgage

Different Types of Mortgage Loan Options

Image courtesy of Flickr, Rach

When it comes to picking the right loan type, none are better than another. It depends on your own goals. Read on to understand the many options available and which may be better for you.

Not all loans are created equal. Some are better if you plan on staying in the same home for many years, while others are better if you plan on relocating in the near future. If you're thinking of buying a new home or refinancing an existing one it's important you understand what options are available so you can make an informed decision.

If you haven't already figured out how much home you can afford click here. Otherwise, take a look at the different types of mortgage loan options below.

Fixed Rate

A mortgage loan with a fixed rate of interest over the life of your loan. In other words, your monthly payment will not change during the life of your loan. Great for those who want to keep a home for a long time and have the peace of mind that mortgage payments will remain predictable. Fixed rate mortgages are available at 30, 20, 15 and 10 years, with the most popular being the 30 year option.

Pros Tips
  • Your monthly payments will not change; helping you plan and budget easier.
  • If interest rates go up, your rate will stay the same because they are not affected by the index market.
  • If rates go down your monthly payment stays the same. You can always try to refinance and take advantage of a lower rate, but be sure it's advantageous to do so due to the way mortgage loans are amortized.

Adjustable Rate

Also known as an ARM, adjustable rate mortgages have a fixed payment for a set period of time and then will adjust, normally to an index such as LIBOR or T-BILL. Every lender offers different initial fixed periods with the most popular being 5, 7, and 10 years before adjusting.

Pros Tips
  • Your monthly payment usually starts off low.
  • If interest rates stay low you'll end up paying less over the long run.
  • Good for people who want to own for a short period of time.
  • ARMs are typically considered riskier because the interest rate, and your monthly payment, may go up to unknown levels according to the index market.
  • It's important to think about how much your monthly payment may increase to and whether or not you'll still be able to afford it.

Interest Only Loan

You pay only the interest on the loan for a fixed term. Afterwards you could pay off the loan, refinance, or pay the principal and interest like a traditional fixed rate mortgage.

Pros Tips
  • Monthly payments are lower than a fixed loan since you're not paying into principal.
  • Allows you to be flexible, especially if you're planning to own the home for a short period of time.
  • You will not build equity on your home unless your home value appreciates.
  • Your loan amount will not decrease.
  • Your ability to pay a higher monthly payment after the interest only period expires is a risk.

FHA Loan

Insured by the Federal Housing Administration (FHA) and typically allows for a lower down payment and credit score. FHA loans can be fixed rate or adjustable rate depending on what your needs are. FHA loans are ideal for first-time home buyers.

Pros Tips
  • Your down payment can be as low as 3.5% making it easier to get into a home.
  • Allows for a lower FICO score and has lessor income requirements making the loan easier to qualify for.
  • Sellers can contribute up to 6% of the loan amount towards closing costs.
  • There's a limit to how much you can borrow.
  • Requires an upfront Mortgage Insurance Premium
  • Requires an annual mortgage insurance premium.

VA Loan

Insured by the Department of Veterans Affairs and is reserved for members of the military, veterans or the current surviving spouse of one.

Pros Tips
  • Your down payment will be reduced, or you won't have one at all.
  • There is no private mortgage insurance.
  • There is no pre-payment penalty.
  • The loan amount has a limit. To be eligible, the lender will require a Certificate of Eligibility (CEO). To obtain one you can go to the U.S Department of Veterans Affairs.

Reverse Mortgage

These loans are available to individuals over 62 years of age. Instead of paying the lender, the lender pays you each month so long as you reside in the home. Interest rate can either be fixed or adjustable.

Pros Tips
  • Good way to convert your equity into income to supplement other retirement income sources or pay medical bills.
  • No debt can be passed on to heirs, and is typically easier to qualify for since there is no income requirement.
  • Loan advances are not taxable and cannot affect your social security benefits.
  • You'll have less equity in your home; therefore your heirs will have to repay the loan in full if they want to own the home.
  • Real estate taxes, homeowners insurance and maintenance is still your responsibility.

Now that you have an idea of the different loan types available, let's test your knowledge with real life scenarios.

Pick the Best Loan Type for James

James graduated college 4 years ago and got a job right away at the same company he had been interning at. He's been living at home with his parents, eats at home and is still under their health insurance. He considers himself conservative and has a high credit score. James makes $72,000 per year and sees a lot of room for growth at his company. He's saved $60,000 and plans on using that money to make a down payment on a small condo where he can walk to work. What type of loan should James get?

Fixed Rate?

A fixed rate would fit James' lifestyle well based on what we know. Not only does he say he's conservative, but his lifestyle certainly reflects that. He may also want to consider an interest only loan because he's still young and has room to grow at his company. The extra savings may also fit him well as it'll help him save money as he has been.

Adjustable Rate?

For James' conservative nature this may not be a good fit. Having the uncertainty that the mortgage payment can fluctuate is too risky. A fixed rate may be a much better choice. Keep in mind too that we don't know his future plans, but he seems to love his company and we do know he is still young and life is just starting. There may be future plans such as getting married and having children. Stability is important.

Interest Only?

Not a bad choice and one that James should consider as an alternative to a fixed rate. Although he is conservative, he has room to grow and is still young, so it's likely he won't be staying at his condo forever. City prices are appreciating more than suburban and rural areas, so the equity built up over the years may be good enough so he can save his money as he has been.

FHA Loan?

Although FHA loans can be either fixed or adjustable, this is not a good option for James as he has good credit and the cash for a decent down payment. A fixed rate mortgage is probably his best choice as it fits his conservative ways well. He may also want to consider an interest only loan too, since he is still young and has growth potential at his company.

Pick the Best Loan Type for Gina

Meet Gina. She's been in sales for 17 years and is now a senior sales person at a large firm. After being unable to get a mortgage due to her husband's low credit score, they eventually bought a home in the city through an FHA loan 5 years ago. Gina has two kids ages 3 and 5. They're ready for a larger home in the suburbs with a large yard. She already travels a lot being in sales, but she would now also have to commute to work. They have significant equity in their current home which will sell quite easily. What type of loan should Gina get?

Fixed Rate?

A fixed rate makes a lot of sense. Gina is about midway though her career and a sales job can be very lucrative, or very slow, depending on the market. Having kids and wanting to slow life down a bit fits well with a fixed rate where the payments are predictable, especially if they plan on upgrading. Additionally, the kids are still young and future expenses will increase.

Adjustable Rate?

Probably a bad idea considering the fact they have two young children and are upgrading their home to a larger one. Stability and predictability is important and a fixed rate fits that well. Additionally, sales careers can have very unstable incomes. Gina doesn't want to be hit with increased mortgage payments during a slow sales year.

Interest Only?

Not a bad choice to consider, but Gina will probably want to go with a fixed rate for a stable and predictable payment. Additionally, a fixed rate will allow them to build equity and eventually pay off their home as they start planning for retirement.

FHA Loan?

FHA loans can either be fixed or adjustable, and a fixed rate FHA loan may be the only choice if her husband's credit score is still low. An adjustable FHA loan is probably not a great idea since they do have young children, are at the middle of their careers and are already upgrading to a larger home.

You Make the Call

At the end of the day you need to decide which loan type best fits your own personal goals. As you can see there are many different routes you can take. It's a big decision and not one that should be taken lightly.

Consider your personal objectives, both near-term and long-term. Where will you be career wise? Will you have additional financial commitments like children, or care for an elderly

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