Types of mortgage loans (1)

Mortgages come in all shapes and sizes. You can see the ads on television or read about them in the newspaper:
‘‘We have over 500 loans programs from which to choose!’’ I can recall working for a mortgage company that had rate sheets for its consumers that were eight pages long with over 125 different loan programs.

Why all the loans?

There really aren’t that many types of loans at all. It’s just that lenders like to make it appear that they are giving you more ‘‘choices’’ than the other lender. But in reality, loans come in two types: fixed rate and adjustable rate.



Fixed Rates
Fixed rates are easy to explain. You get an interest rate when you take out your mortgage, and it’s fixed. It doesn’t change. Ever. Easy enough, right? The only thing you need to decide about your fixed rate is what the rate will be and over what period you’d like to amortize the loan. The amortization period is the fixed period over which your loan will be paid back.

If your amortization period is 20 years, then your loan will be paid off exactly in 20 years and your monthly payments will remain the same, fixed, throughout the life of the mortgage.

Amortization periods can be anything the lender is willing to offer, but if a lender wants the loan to conform to Fannie Mae or Freddie Mac standards (discussed later in the book), then it will be amortized over 10, 15, 20, 25, 30, or sometimes 40 years. The differences between these loans are the rate and how much interest you will pay over the life of the loan. The longer the loan term, the lower your payment, simply because you’re taking a longer period to pay back the lender.

For example, on a $100,000 15-year fixed-rate mortgage, you might get a rate of 5.00 percent. That means that your payments will be $790 per month. After 15 years, you will have paid the lender a total of $142,342. That means that the lender made $42,342 in interest charges.

Borrowing the same amount for 30 years at 5.50 percent works out to a monthly amount of $567. Over 30 years, that adds up to $204,120; the lender makes $104,120 off of you. Yes, the monthly payments are lower with a 30-year loan, but over the long haul you’ve paid more than twice as much interest.

Another point to consider with loan terms is the amount that goes to principal and interest each month. With fixed-rate mortgages, most of the initial payments go to interest, with very little going to principal. But when the loan term is shortened, say from 30 years to 15, you also pay down your principal more quickly.

Using the same information as in the previous example, after 5 years the loan balance on the 30-year loan is $92,316. You’ve paid down your original mortgage only $7,684. With the 15-year loan, your balance is $74,076, a difference of $18,240 after just 5 years.

There’s a trade-off with amortization. Lower payments also mean slower loan paydown. Fixed-rate loans can also have another feature called a balloon. With a balloon, the loan comes due in full after a predetermined period has elapsed. Many conventional loans with balloons come due after five years and are called ‘‘thirty-due-in-five,’’ written as ‘‘30/5.’’ Again using the previous example, after five years your loan balance of $92,316 becomes due, all of it, to the lender. The loan has to be refinanced or paid off in some other way to avoid the balloon payment. Who would want a balloon payment?

Lenders offer balloons because they can offer a reduced interest rate. And these loans are particularly attractive if borrowers don’t think they’ll have the mortgage that long anyway. The interest rate on a 30/5 might be 5.25 percent instead of 5.55 percent.

There’s another version of a fixed-rate loan, sometimes called a ‘‘twostep’’ or a 5/25. This loan offers a reduced initial rate for 5 years, then makes a one-time adjustment to another rate for the remaining 25 years. There are also two-step loans called 7/23s that work similarly.