Types of Mortgage Loans
Are you aware of the benefits and features of the various types of mortgage loans? If not, look at the descriptions below. They will help improve your mortgage knowledge. Once you have a clearer understanding of the different types of home loans, you will be in a better position to choose the type that is right for you!
Table of Contents
Fixed Rate Mortgages (FRMs)
Adjustable Rate Mortgages (ARMs)
Interest Only Loans
Reverse Mortgage Loans
Home Equity Loans
Home Equity Line of Credit (HELOC)
Fixed Rate Mortgages (FRM)
A fixed rate mortgage (FRM) is a mortgage loan where the interest rate on the note remains the same through the term of the loan, and is initially based on an index. This is done to ensure a steady payment amount for the borrower. This payment amount is independent of the additional costs on a home sometimes handled in escrow, such as property taxes and property insurance. Consequently, payments made by the borrower may change over time with the changing escrow amount, but the payments handling the principal and interest on the loan will remain the same.
Fixed rate mortgages (FRM) are characterized by their interest rate, amount of loan, and term (length of time) of the mortgage. With these three values, the calculation of the monthly payment can then be done.
Index
All fixed rate mortgages have an interest rate tied to an index.
Five common indices in the United States are :
- 11th District Cost of Funds Index (COFI)
- London Interbank Offered Rate (LIBOR)
- 12-month Treasury Average Index (MTA)
- Constant Maturity Treasury (CMT)
- National Average Contract Mortgage Rate
Banks may publish a prime lending rate, which is used as the index. The index is then created as the rate plus some margin. To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 2%, 2% being the margin and LIBOR being the index.
Popularity
Fixed rate mortgages (FRM) are the most classic form of loans for
home purchasing in the United States. The most common terms are
15-year and 30-year mortgages, but shorter terms are available,
and 40-year and 50-year mortgages are now available (common in areas
with high priced housing, where even a 30-year term leaves the mortgage
amount out of reach of the average family).
Pricing
Fixed rate mortgages (FRM) are usually more expensive than adjustable
rate mortgages (ARM). Due to the inherent interest rate risk, long-term
fixed rate loans will tend to be at a higher interest rate than
short-term loans. The difference in interest rates between short
and long-term loans is known as the yield curve, which generally
slopes upward ( longer terms are more expensive ).
The fact that a fixed rate mortgage has a higher starting interest rate does not indicate that this is a worse form of borrowing compared to the adjustable rate mortgages (ARM). If interest rates rise, the ARM cost will be higher while the FRM will remain the same. In effect, the lender has agreed to take the interest rate risk on a fixed rate loan. Some studies have shown that the majority of borrowers with adjustable rate mortgages save money in the long term, but that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs. In each case, a choice would need to be made based upon the loan term, the current interest rate, and the likelihood that the rate will increase or decrease during the life of the loan.
Prepayment
Fixed rate mortgages (FRM), like other types of mortgage, may offer
the ability to prepay principal (or capital) early without penalty.
Early payments of part of the principal will reduce the total cost
of the loan (total interest paid), and will shorten the amount of
time needed to pay off the loan. Early payoff of the entire loan
amount through refinancing is sometimes done when interest rates
drop significantly.
Criticism
Fixed rate mortgages (FRM) can sometimes give a false sense
on stability in home costs, when other factors such as property
taxes, property insurance, and property repairs are outside the
scope of the mortgage, compared to renting where those costs are
absorbed by the property owner. However, these factors are also
an issue in variable-rate mortgages.
Adjustable Rate Mortgages (ARMs)
An adjustable rate mortgage (ARM), variable rate mortgage or floating rate mortgage is a mortgage loan where the interest rate on the note is periodically adjusted based on an index. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.
Adjustable rate mortgages are characterized by their index and limitations on charges (caps). In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.
Index
All adjustable rate mortgages have an adjusting interest rate tied
to an index. Five common indices in the United States are :
- 11th District Cost of Funds Index (COFI)
- London Interbank Offered Rate (LIBOR)
- 12-month Treasury Average Index (MTA)
- Constant Maturity Treasury (CMT)
- National Average Contract Mortgage Rate
Banks may publish a prime lending rate, which is used as the index. The index is then created as the rate plus some margin. To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 2%, 2% being the margin and LIBOR being the index.
Limitations on Charges (caps)
Any mortgage where payments made by the borrower may increase over
time brings with it the risk of financial hardship to the borrower.
To limit this risk, limitations on charges ( caps ) are a common
feature of adjustable rate mortgages. Loan caps provide payment
protection against payment shock, and allow a measure of interest
rate certainty to those who gamble with initial fixed rates on ARM
loans.
Caps typically apply to three characteristics of the mortgage :
- frequency of the interest rate change
- periodic change in interest rate
- total change in interest rate over the life of the loan, sometimes called life cap
For example, a given ARM might have the following types of caps :
Interest rate adjustment caps :
- interest adjustments made every 6 months, typically 1% per adjustment, 2% total per year
- interest adjustments made only once a year, typically 2% maximum
- interest rate may adjust no more than 1% in a year
Mortgage payment adjustment caps :
- maximum mortgage payment adjustments of 5% a year, which is common with pay-option / negative amortization loans
Life of loan interest rate adjustment caps :
- total interest rate adjustment limited to 5% of the life of the loan. Most common is 6% lifetime caps.
Popularity
In many countries, it is not feasible for banks to borrow at fixed
rates for very long terms. In these cases, the only feasible type
of mortgage for banks to offer may be adjustable rate mortgages.
For those who plan to move within a relatively short period of time (three to seven years), they are attractive because they often include a lower, fixed rate of interest for the first three, five, or seven years of the loan, after which the interest rate fluctuates.
Pricing
Adjustable rate mortgages are typically, but not always, less expensive
than fixed-rate mortgages. Due to the inherent interest rate risk,
long-term fixed rates will tend to be higher than short-term rates
(which are the basis for variable-rate loans and mortgages). The
difference in interest rates between short and long-term loans is
known as the yield curve, which generally slopes upward (longer
terms are more expensive).
The fact that an adjustable rate mortgage has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates change). If rates rise, the cost will be higher; if rates go down, the rate will be lower. In effect, the borrower has agreed to take the interest rate risk. Some studies have shown that on average, the majority of borrowers with adjustable rate mortgages save money in the long term; but they have also demonstrated that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs.
Prepayment
Adjustable rate mortgages, like other types of mortgage, may offer
the ability to repay principal (or capital) early without penalty.
Early payments of part of the principal will reduce the total cost
of the loan (total interest paid), and will shorten the amount of
time needed to pay off the loan. Early payoff of the entire loan
amount through refinancing is sometimes done when interest rates
drop significantly.
Criticism
Adjustable rate mortgages are sometimes sold to unsophisticated
consumers who are unlikely to be able to repay the loan should interest
rates rise. Extreme cases are characterized by the Consumer Federation
of America as “predatory loans.” Protections against interest rate
rises include (a) a possible initial period with a fixed rate (which
gives the borrower a chance to increase his/her annual earnings
before payments rise); (b) a maximum (cap) that interest rates can
rise in any year (if there is a cap, it must be specified in the
loan document); and (c) a maximum (cap) that interest rates can
rise over the life of the mortgage (this also must be specified
in the loan document).
Interest Only Loans (IO)
An interest-only loan is a loan in which for a set term the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan.
A five or ten year interest-only period is typical. After this time, the principal balance is amortized for the remaining term. In other words, if a borrower had a thirty-year mortgage and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized for the remaining period of twenty years. The practical result is that the early repayments (in the interest-only period) are substantially lower than the later repayments. This enables a borrower who expects to increase their salary substantially over the course of the loan to borrow more than they would have otherwise been able to afford, or investors to generate cash flow when they might not otherwise be able to. During the interest-only years of the mortgage, one is essentially renting the house since none of the principal loan decreases. The two great disadvantages are that in many states one has to pay property tax and purchase mandatory property insurance. On the other hand, the owner is still gathering appreciation, even if they are not paying down equity against their loan, and there are many other tax advantages to home ownership not available to renters.
Reverse Mortgage Loans
A reverse mortgage is a loan available to senior citizens, and is used to release the home equity in the property as one lump sum or multiple payments. The homeowner’s obligation to repay the loan is deferred until the owner dies, the home is sold, or the owner leaves.
In a typical mortgage, the homeowner makes a monthly-amortized payment to the lender; after each payment, the equity increases within their property, and typically after 30 years, the mortgage is paid in full and the property is released from the lender. In a reverse mortgage, the homeowner makes no payments and all interest is added to the lien on the property. If the owner receives monthly payments, then the debt on the property increases each month.
If a property has increased in value after a reverse mortgage is taken out, it is possible to acquire a second (or third) reverse mortgage over the increased equity in the home. However, a reverse mortgage must be the first and only mortgage on the property.
Requirements
To qualify for a reverse mortgage, the borrower must be at least
62. The borrower must pay off any existing mortgages with the proceeds
from the reverse mortgage and, if needed, additional personal funds.
There are no minimum income or credit requirements, and for most
reverse mortgages, the money can be used for any purpose. A pending
bankruptcy that has not been finalized may, however, slow the process.
Some types of dwellings, such as lower-value mobile homes, do not
qualify. Before borrowing, applicants must seek HUD approved counseling.
The counseling is a free safeguard for the borrower and his/her
family, to make sure they completely understand what a reverse mortgage
is, and what the process of obtaining one is.
Reverse mortgages are offered by some state and local governments. These "public sector" loans generally must be used for specific purposes, such as paying for home repairs or property taxes. The majority of reverse mortgages are FHA insured.
Payments (loan advances)
The amount of money that an individual homeowner can receive from
a reverse mortgage depends on their age, the Federal Housing Administration
(FHA) or Fannie Mae (FNMA) appraised value of the home, and the
starting interest rate. The location of the home may also have an
impact. There is also a type of reverse mortgage for homes valued
over the maximum Fannie Mae limit. These are called "cash" accounts,
and are proprietary loan products.
In a reverse mortgage, a borrower can be paid in a lump sum, monthly (payment of advances), through an increasing line of credit, or a combination of all three. The money received (loan advances) are not taxable and do not affect Social Security or Medicare benefits.
A borrower can elect to move available funds into a "set-aside" account, similar to a typical escrow account, to pay for their future property taxes and/or homeowners insurance. Currently, most reverse mortgage borrowers do not exercise this option and instead elect to be responsible for the payment of taxes and/or insurance on their own. It is important to note that the homeowner must ensure that taxes and insurance are kept current at all times. If either taxes or insurance lapse, it could result in a default on the reverse mortgage.
If you receive Medicaid, SSI, or other public benefits, loan advances will be counted as "liquid assets" if the money is kept in an account (savings, checking, etc.) past the end of the calendar month in which it is received. The borrower could then lose eligibility for such public programs if their total liquid assets (cash, generally) is then greater than those programs allow.
Costs and Interest Rates
The cost of getting a reverse mortgage from a private sector lender
tends to exceed the costs of other types of mortgage or equity conversion
loans. Exact costs however are dependent on the particular reverse
mortgage program that the borrower acquires. For the most common
type of reverse mortgage, the HECM (Home Equity Conversion Mortgage),
there is an insurance premium of 2 percent of the loan and a 2 percent
origination fee in addition to normal closing costs, which are typically
some thousands of dollars, but vary depending on the third-party
costs (appraisal fees, title searches, etc.) that must be undertaken.
Thus a $200,000 loan would have $8,000 in costs beyond the normal
closing costs added onto the loan at the outset.
The costs of a reverse mortgage can typically be financed through the loan itself, with the costs and fees being rolled directly into the principal balance of the loan, rather than paid by the borrower in cash. While this does permit borrowers with little or no available cash to get a reverse mortgage, it does mean that the initial loan principal will be increased, and consequently, that the fees will begin accruing interest.
Interest rates on reverse mortgages are determined on a program-by-program basis, but are typically similar to interest rates offered by adjustable rate mortgages (ARMs), or at time of this writing, approximately 7-8%. All major reverse mortgage programs have adjustable interest rates that are adjusted on an annual, semi-annual, or monthly basis. Because reverse mortgages have no fixed duration, there are no reverse mortgages with fixed interest rates.
When the Loan Ends
The loan ends when the homeowner dies, sells the house, or moves
out of the house for 12 consecutive months or more. At that point,
the reverse mortgage can be paid off by the proceeds of the sale
of the house, or refinanced by the heirs of the homeowner's estate.
If the proceeds exceed the loan amount, the owner of the house (if
moving out or selling) receives the difference; if the owner has
died, the heirs receive the difference. For cases where the proceeds
are not sufficient to pay off the loan, then the bank makes up the
difference.
In most cases when the borrower moves out of the property or passes away, as long as the borrower (or their estate) provides proof to the lender that they are attempting to sell the home or obtain financing to pay off the outstanding debt, the investor will allow them up to one year to do so. After the one-year extension period is up, the lender cannot provide any further extension of time to the borrower (or estate).
The technical term for this cap on debt is "non-recourse limit." It means that the lender does not have legal recourse to anything other than the value of the home when the loan is to be paid off.
Other Options
The biggest drawback with reverse mortgages are the high upfront
costs. Some seniors may want to consider other options to tap their
home equity, particularly if they do not think they will remain
in the home for at least five years.
For example, a home equity line of credit (HELOC) requiring interest-only payments for 10 years can be used. These loans typically have very low (or zero) upfront costs. The drawback is that, unlike a reverse mortgage, the borrower must make a monthly (interest-only) payment to the lender. These payments can be made for several years by drawing on the line of credit itself. Of course, the balance needs to be paid off when the house is sold or the owner dies - just as with a reverse mortgage.
Home Equity Loans
A home equity loan is a type of loan in which the borrower uses the equity in their home as collateral. These loans are sometimes useful for families to help finance major home repairs, medical bills or college educations. A home equity loan creates a lien against the borrower's house.
Home equity loans are most commonly second position liens (second trust deed), although they can be held in first or, less commonly, third position. Most home equity loans require good to excellent credit history, and reasonable loan-to-value and combined loan-to-value ratios. Home equity loans come in two types, closed end and open end.
Both are usually referred to as second mortgages, because they are secured against the value of the property, just like a traditional mortgage. Home equity loans and lines of credit are usually, but not always, for a shorter term than first mortgages. It is sometimes possible to deduct home equity loan interest on one's personal income taxes.
Closed End Home Equity Loans
The borrower receives a lump sum at the time of the closing and
cannot borrow further. The maximum amount of money that can be borrowed
is determined by variables including credit history, income, and
the appraised value of the collateral, among others. It is common
to be able to borrow up to 100% of the appraised value of the home,
less any liens, although there are lenders that will go above 100%
when doing over-equity loans. However, state law governs in this
area.
Closed-end home equity loans generally have fixed rates and can be amortized for periods usually up to 15 years. Some home equity loans offer reduced amortization whereby at the end of the term, a balloon payment is due. These larger lump-sum payments can be avoided by paying above the minimum payment or refinancing the loan.
Open End Home Equity Loans
This is a revolving credit loan, also referred to as a home equity
line of credit (HELOC), where the borrower can choose when and how
often to borrow against the equity in the property, with the lender
setting an initial limit to the credit line based on criteria similar
to those used for closed-end loans. Like the closed-end loan, it
may be possible to borrow up to 100% of the value of a home, less
any liens. These lines of credit are available up to 30 years, usually
at a variable interest rate. The minimum monthly payment can be
as low as only the interest that is due.
Home Equity Loan Fees
Here is a brief list of possible fees that may apply to your home
equity loan: Appraisal fees, originator fees, title fees, stamp
duties, arrangement fees, closing fees, early pay-off and other
costs are often included in loans. Surveyor and conveyor or valuation
fees may also apply to loans, some may be waived. The survey or
conveyor and valuation costs can often be reduced, provided you
find your own licensed surveyor to inspect the property considered
for purchase. The title charges in secondary mortgages or equity
loans are often fees for renewing the title information. Most loans
will have fees of some sort, so make sure you read and ask several
questions about the fees that are charged.
Home Equity Line of Credit (HELCO)
A Home Equity Line of Credit (often called HELOC, pronounced HEE-lock) is a loan in which the lender agrees to lend a maximum amount within an agreed period (called a term), where the collateral is the borrower's equity in his/her house.
A HELOC differs from a conventional home equity loan in that the borrower is not advanced the entire sum up front, but uses the line of credit to borrow sums that total no more than the amount, similar to a credit card. At closing, you are assigned a specified credit limit that you can borrow. During a "draw period" (typically 5 to 25 years), HELOC funds can be borrowed "on demand" and you pay back only what you use plus interest. Depending on how much you use the HELOC, you will have a minimum monthly payment requirement (often "interest only"); beyond the minimum, it is up to you how much to pay and when to pay. At the end of the draw period, you will have to pay back the full principal amount borrowed either in a lump-sum balloon payment or according to a loan amortization schedule.
Another important difference from a conventional loan: the interest rate on a HELOC is variable based on an index such as prime rate. This means that the interest rate can - and almost certainly will - change over time.
HELOC loans have become very popular, in part because interest paid is typically (depending on specific circumstances) deductible under federal and many state income tax laws. This effectively reduces the cost of borrowing funds. Another reason for the popularity of HELOCs is the flexibility not found in most other loans - both in terms of borrowing "on demand" and repaying on a schedule determined by the borrower. Furthermore, HELOC loans popularity growth may also stem from their having a better image than a "second mortgage," a term that can more directly imply an undesirable level of debt.
It must always be kept in mind that the underlying collateral of a home equity line of credit (HELOC) is the home. This means that failure to repay the loan or meet loan requirements may result in foreclosure.
