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Understanding
Different Types of Loans
Today's homebuyer has more
financing options than have ever been available before. From traditional
mortgages to adjustable-rate and hybrid loans, there are financing packages
designed to meet the needs of virtually anyone.
While the different choices
may seem overwhelming at first, the overall goal is really quite simple: you
want to find a loan that fits both your current financial situation and your
future plans. Though this article discusses some of the more common loan types,
you should spend time talking with different lenders before deciding on the
right loan for your situation.
General categories of loans
Most loans fall into three major categories: fixed-rate, adjustable-rate, and
hybrid loans that combine features of both.
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Fixed-rate mortgages
As the name implies, a fixed-rate mortgage carries the same interest rate for
the life of the loan. Traditionally, fixed-rate mortgages have been the most
popular choice among homeowners, because the fixed monthly payment is easy to
plan and budget for, and can help protect against inflation. Fixed-rate
mortgages are most common in 30-year and 15-year terms, but recently more
lenders have begun offering 20-year and 40-year loans.
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Adjustable-rate mortgages (ARM)
Adjustable-rate mortgages differ from fixed-rate mortgages in that the
interest rate and monthly payment can change over the life of the loan. This
is because the interest rate for an ARM is tied to an index (such as Treasury
Securities) that may rise or fall over time. In order to protect against
dramatic increases in the rate, ARM loans usually have caps that limit the
rate from rising above a certain amount between adjustments (i.e. no more than
2 percent a year), as well as a ceiling on how much the rate can go up during
the life of the loan (i.e. no more than 6 percent). With these protections and
low introductory rates, ARM loans have become the most widely accepted
alternative to fixed-rate mortgages.
- Hybrid loans
Hybrid loans combine features of both fixed-rate and adjustable-rate
mortgages. Typically, a hybrid loan may start with a fixed-rate for a certain
length of time, and then later convert to an adjustable-rate mortgage.
However, be sure to check with your lender and find out how much the rate may
increase after the conversion, as some hybrid loans do not have interest rate
caps for the first adjustment period.
Other hybrid loans may start
with a fixed interest rate for several years, and then later change to another
(usually higher) fixed interest rate for the remainder of the loan term. Lenders
frequently charge a lower introductory interest rate for hybrid loans vs. a
traditional fixed-rate mortgage, which makes hybrid loans attractive to
homeowners who desire the stability of a fixed-rate, but only plan to stay in
their properties for a short time.
Balloon payments
A balloon payment refers to a loan that has a large, final payment due at the
end of the loan. For example, there are currently fixed-rate loans which allow
homeowners to make payments based on a 30-year loan, even thought the entire
balance of the loan may be due (the balloon payment) after 7 years. As with some
hybrid loans, balloon loans may be attractive to homeowners who do not plan to
stay in their house more than a short period of time.
Time as a factor in your loan choice
As has been discussed, the length of time you plan to own a property may have a
strong influence on the type of loan you choose. For example, if you plan to
stay in a home for 10 years or longer, a traditional fixed-rate mortgage may be
your best bet. But if you plan on owning a home for a very short period (5 years
or less), then the low introductory rate of an adjustable-rate mortgage may make
the most financial sense. In general, ARMs have the lowest introductory interest
rates, followed by hybrid loans, and then traditional fixed-rate mortgages.
FHA and VA loans
U.S. government loan programs such as those of the Federal Housing Authority
(FHA) and Department of Veterans Affairs (VA) are designed to promote home
ownership for people who might not otherwise be able to qualify for a
conventional loan. Both FHA and VA loans have lower qualifying ratios than
conventional loans, and often require smaller or no down payments.
Bear in mind, however, that
FHA and VA loans are not issued by the government; rather, the loans are made by
private lenders but insured by the U.S. government in case the borrower
defaults. Remember too, that while any U.S. citizen may apply for a FHA loan, VA
loans are only available to veterans or their spouses and certain government
employees.
Conventional loans
A
conventional loan is simply a loan offered by a traditional private lender. They
may be fixed-rate, adjustable, hybrid or other types. While conventional loans
may be harder to qualify for than government-backed loans, they often require
less paperwork and typically do not have a maximum allowable amount.
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