There are so many types of mortgages that interested home buyers often feel overwhelmed by the abundant offer. Brace up and dive into the details! You cannot tell which loan is right for you without knowing something about the types of loans available with their pros and cons. In the following lines we’ll take a look at one year adjustable rate mortgages, fixed rate mortgages, 2-step mortgages, 10/1 adjustable rate mortgages, 5/5 and 5/1 adjustable rate mortgages, 3/3 and 3/1 adjustable rate mortgages, 5/25 mortgages, and balloon mortgages. This should make the loan comparison more accessible.
Fixed Rate Mortgages
A fixed rate mortgage requires the same monthly payment throughout the length of the loan. Almost 75% of homes are financed using a fixed rate mortgage. Variations do exist in the loan length: there could be a 10-, 15- or 30-year loan with possible difference in interest rate.
The main advantage of such a mortgage is that the amount you pay every month remains the same. Moreover, borrowers know when exactly they pay for the interest and when for the loan principal. From a general point of view, this is really convenient as you can budget a lot easier. Without unexpected changes in the interest rate, you know where your money goes.
Fixed rate mortgages enjoy the highest popularity and have the highest predictability of all loan products. The rate is part of the initial agreement and it remains unchanged. In case interest rates go down on the market, the borrower has the option of refinancing to reduce the monthly payment. Keep in mind that closing costs incur with refinance. In comparison with other types of loans, fixed-rate mortgages have a higher interest rate and thus a higher monthly payment.
One-Year Adjustable Rate Mortgages
An adjustable rate mortgage or ARM is a type of loan in which the interest rate varies according to periodical adjustments. The changes in the interest rate represent the highest disadvantage of this type of loan as the monthly payment could increase significantly. Lenders try to ‘soothe’ clients by offering them a lower interest rate as compared to the traditional 30-year fixed rate mortgage. With a 1-year ARM, the interest is adjusted every year on the anniversary of the loan, and it will change 30 times during the life of the loan.
Some borrowers prefer a one-year adjustable rate in order to qualify for a higher loan amount and thus be able to buy a more expensive home. There are cases when borrowers with large mortgages refinance them every year. They thus manage to keep the monthly payment lower while also owning a more valuable property. However, lured by the attractive interest rate, you might turn a blind eye on the ARM risks. The situation can change to your detriment at the end of the year.
10/1 Adjustable Rate Mortgages
The 10/1 ARM speaks its name: the rate is fixed for the first 10 years of the loan. At the end of this period, the interest rate adjusts yearly for the remaining life of the loan. The difference from the 30-year fixed rate mortgage lies in the lower interest rate, particularly during the fixed-rate decade. Nevertheless, experts agree that an ARM is not a good choice for people who intend to own the home for more than 10 years.
A two-step mortgage is a type of loan that has the same interest rate for part of the loan and a different rate for the rest of the mortgage. The lender operates periodical interest rate adjustments depending on the current market rates and index fluctuations. At the date of the adjustment, the borrower could be allowed to choose between a variable interest rate and a fixed interest rate.
If you are interested in contracting a 2-step mortgage you should be aware of its risks. Thus, when the fixed-rate period expires, the adjustment of the interest rate may trigger an increase of the monthly rate. In the majority of cases, borrowers who select this type of loan plan to move out of the home or refinance at the end of the fixed-rate period.
5/5 and 5/1 Adjustable Rate Mortgages
The 5/5 and the 5/1 adjustable rate mortgages are characterized by a fixed 5-year period during which no adjustments are operated on the interest rate. With this kind of ARM, the monthly payments will remain unchanged only for the first 5 years. The interest rate changes afterward. If you have a 5/1 ARM, there will follow a yearly adjustment; if you contract a 5/5, then the adjustments are made every 5 years.
This kind of adjustable rate mortgages suit the needs of homeowners who intend to live in the house for more than five years. Moreover, borrowers should also have a plan of how to deal with the loan changes at the end of the 5-year period.
5/25 Mortgage Loans
The 5/25 mortgage or “30 due in 5” is a peculiar loan type characterized by a single interest rate change throughout the life of the mortgage. There is an initial 5-year period with a preset interest rate and, then, at the beginning of the 6th year, the interest rate adjusts according to current interest rates. After this adjustment no more modifications occur in the monthly payment. This is considered an advantageous type of mortgage on the sole condition that the borrower should be able to deal with the rate adjustment.
3/3 and 3/1 Adjustable Rate Mortgages
3/3 and 3/1 adjustable rate mortgages start with a 3-year fixed-rate period. The borrower pays the same amount each month for the specified period of time (i.e. three years). In the case of the 3/3 loan, the interest rate changes every three years starting with the fourth year of the loan, whereas for the 3/1 loan, the interest rate changes every year from the 4th year onwards. For borrowers who find the 3-year adjustment period convenient, such ARMs could prove a good choice.
Balloon Mortgage Loans
Balloon mortgages resemble fixed-rate mortgages but have a considerably shorter term. The monthly payments are considerably lower but there is a balloon payment at the end of the loan. The borrower pays the interest rate during the term of the loan, and the principal remains at the end. Balloon loans work well only for the highly responsible borrower who intends to sell the house by the time of the balloon payment. Big trouble may be around the corner if the homeowner cannot pay off the loan at its end. There are cases when the borrower cannot refinance with the lender of the balloon mortgage, and that could lead to default.