You may think that getting a mortgage is hard enough, but wait until you find out that there are all different types of mortgages. So how do you know which mortgage to choose? It all comes down to understanding the options available so you can choose what’s right for your situation. Let’s dive deeper into the different types of mortgages.
A fixed-rate mortgage is a mortgage where the interest rate doesn’t change over the life of the loan. If you get a 3% or 4% rate, you pay 3% or 4% until you pay off your mortgage or refinance. The amount of your payment that goes to interest gets smaller as you pay down the principal, but the percentage never changes.
Example: $100,000 mortgage, 3% rate
- You’ll pay about $3,000 in interest the first year (3% of $100,000). It will actually be a little less because you’ll pay the principal down over the year, but that’s close enough to illustrate this example.
- In the year you’ve paid your principal down to $50,000, you’ll pay about $1,500 in interest. That’s 3% of $50,000.
An adjustable-rate mortgage is a mortgage where your interest rate regularly changes over the life of the loan. The rate is usually an index, such as the Federal Funds Rate, plus an additional margin added by your lender. The margin stays fixed while the index changes.
For example, say your mortgage is for the current federal funds rate plus 3%. As of June 1st, the Federal Funds Rate is 0.06%. Your interest rate today is 3.06% (3% + 3.06%). If the Federal Funds Rate increases to 1%, your new interest rate would be 4% (3% + 1%). Your mortgage contract will say when your rate adjusts whether that’s when the Fed changes rates, monthly, or quarterly.
Unlike a fixed-rate mortgage, you never know exactly how much you will pay in interest each year.
Example: $100,000 mortgage, starting at a 3% rate (same as the fixed-rate example)
- In the first year, you can still expect to pay about $3,000 in interest (3% of $100,000)
- Now let’s say that in the year your principal is down to $50,000, your rate has increased to 6%. You’ll still pay $3,000 in interest (6% of $50,000) because even though your principal went down by half, your interest rate doubled.
Note that your monthly payment also usually changes when your interest rate changes so that you still pay off your loan by the same date. If rates rise, your payments go up. If rates fall, your payments go down.
So why would anyone choose adjustable-rate? In today’s low rate environment, it’s probably a bad move. When interest rates are higher, you usually get a discount on the initial rate versus a fix-rate mortgage and are betting that interest rates will stay the same or go down.
An FHA loan is a government-backed loan run by the Federal Housing Administration. These loans have easier credit requirements and a smaller minimum down payment. It’s also easier to finance closing costs that you’re paying for as the buyer.
The tradeoff is that you have to pay a mortgage insurance premium both as part of your closing costs and as part of your ongoing payments. This can raise your total cost of borrowing versus a non-FHA loan.
A VA loan is a benefit for veterans or current service members. The Department of Veterans Affairs guarantees part of the loan, so the lender offers more favorable terms.
Benefits of VA loans include no required down payment and no mortgage insurance premium. You can also finance closing costs if needed. A VA loan is almost always the best (least expensive) option if you qualify for one.
An interest-only mortgage is a mortgage where you only pay interest for a period of time. Normally, you’d pay interest-only payments for a few years then start making principal payments later on. Mortgages where you only pay interest until the end are rare.
The benefit of an interest-only loan is that you start off with much lower payments than you would with a mortgage where you’re also making principal payments. This can be useful if you’re early in your career and expecting your income to go up. Some people also use this type of mortgage when they’re expecting home values to go up so they can sell at a gain or refinance based on the increased value.
Interest-only loans can be hard to get because they’re riskier to banks. Especially during times of financial crisis, banks have more defaults once principal payments kick in and the borrower can’t make the increased payments. This could mean they offer you a higher interest rate. In addition, if you don’t start paying down the principal early, you’ll pay more interest over the life of the loan.
A balloon mortgage is similar to an interest-only mortgage. You make smaller payments, including some principal, during the loan and then have a large payment at the end. The loan length is usually for several years rather than 20 to 30.
Many borrowers who use a balloon mortgage intend to move and sell before the end of the mortgage. Others are expecting their income to go up and will then refinance into a more traditional mortgage when they can afford the higher payment.
Balloon mortgages are risky to both the borrower and the lender, so they are also harder to get or could have higher interest rates.
A jumbo mortgage is when you’re buying a jumbo house. You can typically only borrow so much with standard mortgages. This is usually half a million to a million dollars depending on the local cost of living. Jumbo mortgages let you borrow more.
The catch is that qualifying is much harder. You need a higher credit score and larger down payment. Debt-to-income ratio requirements still apply — a jumbo mortgage doesn’t let you borrow a higher percent of your income. You’ll also generally need to prove cash, investment, or other real estate assets.
A construction loan is a temporary loan if you’re paying for the construction of a new home. It’s typically good for a year, and then you refinance into a standard mortgage once you’ve finished construction. Construction loans are usually when you’re building a custom home as a standalone project.
If you’re buying from a builder in a new development, they usually finance construction. You pay a deposit to the builder and then use a traditional mortgage when you close on the finished home.
You may also hear about 15 or 30-year mortgages. These are just different lengths of the types of mortgages discussed above. You can have a 15-year fixed-rate mortgage, a 30-year FHA loan, or practically any other combination. Your mortgage can also be a different length, but 15 and 30 years are the most common options.
A shorter mortgage usually means higher payments, a lower interest rate, and less total interest paid. A longer mortgage usually has a lower payment and a higher interest rate. You would choose the longer term when you need the lower payment or want more flexibility to choose when to pay off the loan.
Even when you know about the different types of mortgages, it can still be hard to choose which one is best and LemonBrew is here to help. Answer a few simple questions and our top-rated mortgage advisors will help you decide how to finance your new home and help you better understand all of the different types of mortgages.