Mortgages 101: Types of Residential Mortgages
Types of Mortgages
Conventional mortgages are the preferred mortgage type for most sellers. Over the lifetime of the mortgage, conventional mortgages are almost always the cheapest. Conventional mortgages require higher credit scores and require larger down payments. Conventional mortgages require mortgage insurance if your down payment is less than 20%. Once you have more than 20% equity in your home—either initially or after making payments—mortgage insurance is no longer required. If the mortgage starts with mortgage insurance, you can request the lender remove it at 20% equity. Conventional mortgages have lenient appraisal requirements and allow larger mortgage amounts. The fees associated with conventional mortgages are almost always lower than the fees associated with FHA mortgages.
Federal Housing Administration (FHA) mortgages are backed by the government. They are intended to make housing available for lower income home buyers. FHA mortgages have lower credit score requirements and require only a 3.5% down payment. The downsides of an FHA mortgage include mandatory mortgage insurance that can never be removed, higher fees when getting the mortgage, some of the fees must be paid by the seller which also makes your offer weaker, more stringent appraisal requirements, and limits on the mortgage size.
Veterans Affairs (VA) mortgages are a special type of mortgage only available to active or former members of the military and surviving spouses. VA mortgages have several key benefits over conventional and FHA mortgages. VA mortgages have no down payment requirements and lower fees that can be rolled into the mortgage amount—resulting in no fees due at closing. The interest rate is frequently lower too. The primary drawback of VA mortgages is even more stringent appraisal requirements. The appraisals are a combination of appraisal and home inspection, if the appraiser finds anything that doesn’t meet the VA’s minimum standards then the mortgage will be declined.
Interest Rate Types
Fixed rate mortgages have the same interest rate for the entire duration of the mortgage. The interest rate can only change if the home is refinanced (which is the creation of a new mortgage to fully pay the original). Fixed-rate mortgages usually have higher interest rates than ARM mortgages, but the stable payment amount makes these mortgages safer.
Adjustable-rate mortgages on the other hand have a variable interest rate. The interest rate for an ARM mortgage will float with market rate interest rates. The rate of change for ARM interest rates do have some restrictions:
Adjustment Frequency: How often the interest rate can be adjusted. This may vary from several months to a year or more.
Adjustment Index: A market indication that is used to determine interest rates. The most common index used to determine interest rates is the yield of US Treasury Bills.
Margin: The interest rate you agree to pay in relation to the adjustment index. For example, you could agree to pay 2% more than the 10 Year US Treasury Bill rate.
Caps: Limits the amount of change in the interest rate between adjustment periods. The cap will help protect you from rapid increases in interest rates, but it also prevents you from fully realizing rapid decreases in interest rates.
Ceiling: The maximum interest rate that the mortgage can increase to.
The primary benefit of an ARM mortgage is a lower starting interest rate. If you plan to own the property for a brief time, an ARM mortgage can be a great option. However, if you plan to own the property long-term you are taking a risk. If interest rates rise beyond what you can afford you might be forced to sell your home.
Other Types of Loans
Bridge loans are a temporary loan used by buyers to purchase a new home prior to selling their current home. A bridge loan gives the buyer money to make a down payment on the property they wish to purchase without taking money out of their pocket. The greatest drawback of a bridge loan is the interest rate which can be significantly higher than normal interest rates. A home buyer using a bridge loan also has to contend with 3 payments in a month—2 mortgage payments and the bridge loan—until the original home sells. This loan is risky and should only be used if you are comfortable with your finances and just need short-term liquidity (1 to 2 months) while moving.
Construction loans are a short-term loan used to fund the construction of a new home. The interest rate of a construction loan is usually higher than normal interest rates. The format of a construction loan can be complex and varies by lender. The loans usually rely on a draw schedule which ties money withdrawals to construction progress. The loans frequently contain contingency funds to handle cost overruns. Once the home is complete the construction loan will be paid in full and a conventional or FHA mortgage will be initiated.
