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6 Types of Mortgages Explained

By
Peter Andrew
  • Loans
  • 6 minute read

With so many different types of mortgages, it can be tough to work out which is best for you. Here’s an introduction to the six most popular types of mortgages that you’ll be researching during your adventures in househunting.

1. Fixed-rate mortgages

Fixed-rate mortgages (FRMs) are by far the most popular type of home loan in America, even though they generally have higher interest rates than other products. There’s a good reason for that popularity: once you have an FRM in place, you don’t have to worry about mortgage rates going up. Your monthly payments are going to be the same throughout the term of the loan, and — assuming you keep up your end of the deal — your loan should be paid off in full when you make your last scheduled payment. You’re paying a bit more for peace of mind, and — if mortgage rates rise — you may well end up with a cheaper loan overall than those who choose adjustable-rate products.

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Most FRMs have 15-year or 30-year terms. As you’d expect, monthly payments for the same loan amount are considerably higher for the shorter mortgage, but the overall cost across the entire lifetime of the loan is generally much lower. You’ll be likely better off with the shortest term you can get, but most of us can’t afford that option, and instead choose 30-year FRMs.

2. Adjustable-rate mortgages

Most economists expect home loan rates to continue to rise, so those with adjustable-rate mortgages (ARMs) could in the future find themselves paying more than those with FRMs. However, ARMs typically have significantly lower initial interest rates than FRMs. Critically, most of these loans are “hybrid ARMs,” which means the rate is fixed for an agreed period of time, often one, five or seven years, but you can find them for up to 10 years. After that, the rate floats according to agreed rules, which usually include a cap on the maximum rate chargeable, perhaps 5 percentage points over the initial fixed rate.

If you’re absolutely certain you’re going to move home again during that fixed-rate period (and the U.S. Census reports close to one in three Americans aged 5 or over moved during the five years between 2005 and 2010), then you can safely take advantage of those lower initial rates.

3. FHA loans

The Federal Housing Administration (FHA) is a government body that partly guarantees loans made by private lenders to people who might otherwise not qualify for mortgages. The guarantee allows those lenders to lower the criteria they normally use to assess prospective borrowers. As a result, the FHA website says, you may qualify even if you have:

  • A less than spotless credit record — though you can’t still be in trouble, and your credit score is still likely to have to meet minimum thresholds.
  • A smaller down payment than usual. The minimum for an FHA loan is typically 3.5 percent of the appraised value of the home.

4. VA loans

U.S. Department of Veterans Affairs (VA) loans work on exactly the same principles as FHA ones. However, as a mark of respect for those who’ve served their country, they allow those who meet strict eligibility criteria to find it yet easier to qualify for mortgages. Indeed, the VA website says you may qualify with even spottier credit and with no down payment at all. VA loans may also be less expensive overall than FHA and other loans.

5. Balloon mortgages

Balloon mortgages are less popular than they once were, partly because they’re inherently more risky than many other types of mortgage — and American consumers have had less of an appetite for risk since the credit crash. You can think of a balloon mortgage as similar to a hybrid ARM (see above) insofar as its monthly payments are also low (sometimes lower), and are fixed over an agreed period, maybe five, seven or 10 years. However, while a hybrid ARM will then see its rate float, a balloon loan must be paid back in full at that time with a single, large “balloon” payment.

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Of course, few borrowers are able to make that huge payment without either selling their home or refinancing. And that’s where the risk comes in: suppose you’re unable to sell because of a poor housing market, or refinance owing to your loan being underwater or your credit being shot.

6. Interest-only mortgages

Just like balloon mortgages, interest-only home loans are less popular than they once were because they carry risk. The monthly payment on a traditional FRM or ARM comprises two elements: the interest due, and a chunk of money that pays down the principal (the amount you borrowed). As its name implies, an interest-only loan pays only the first of those, which makes those monthly payments much lower. However, the principal generally remains the same from the day you close your purchase to the day the last payment is made.

So on that last day, you owe the same amount you started out with. That may turn out fine if you’ve built up savings and investments to clear the debt, or if you can sell your home and use the equity you’ve acquired to buy a smaller one, or if you can refinance. However, as we’ve seen in recent years, there are few certainties in our personal finances.

There’s no such thing as the “best” mortgage for everyone, but there is a “best” for you. Which it is will depend on your financial position, your credit, your family circumstances, your expectations, your needs and your appetite for risk. But with so much money at stake, it’s worth thinking carefully about your choice.