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What are the four kinds of mortgages and how do they differ?

Asked by Trulia Houston, Houston, TX Mon Nov 19, 2012

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The 30-year fixed-rate mortgage
Not long ago, there was only one kind of mortgage: 30-year fixed rate (the borrower has 30 years to pay back the mortgage at a fixed interest rate and the payments are the same over the life of the loan). It is still the most common home loan.

Borrowers choose fixed-rate loans because the mortgage payments are steady and predictable, allowing for easier household budgeting and planning. The payments are the same over the life of the mortgage, regardless of interest rate changes. Initially, both the rate and mortgage payment are higher than those of an adjustable-rate mortgage, but the payment is lower than that of a 15-year fixed-rate mortgage (see below). People who choose a fixed-rate mortgage usually are planning to keep their home and mortgage for several years.

The 15-year fixed-rate mortgage
This type of mortgage enables you to own your home in half the usual time, meaning you could possibly own it before your children start college or you reach retirement. Because the loan is shorter, you pay substantially less in the total interest over the life of the loan, often less than half the total interest of a 30-year fixed-rate loan. However, because the term is shorter, the monthly payments are higher than those of a 30-year mortgage. For people who can afford the higher monthly payments, this is an excellent choice, with lower total costs and a shorter term. Qualification for this type of loan may be more difficult because the income requirement may be higher.

The adjustable rate mortgage (ARM)
In general, adjustable-rate mortgages can offer lower interest rates and mortgage payments at first because the borrower assumes the risk of changes in interest rates. Usually borrowers choose ARMs because the lower initial payment makes the home more affordable at first, but the borrower must be willing to accept the risk of an increased mortgage payment, which can sometimes be significantly higher.

After a specified period of time, the interest rate and payments on an ARM are adjusted based on changes to a specific interest rate index (such as the LIBOR rate). These adjustments occur at times specified in the ARM disclosure you receive from the lender and can result in payment increases. There is always a floor cap, payment cap, and life cap on the rate. It's important to understand all the aspects of ARMs before you make your decision.

People who choose an ARM usually are intending to sell or refinance before the rate adjusts upward. They also may expect income to increase over time. These borrowers must be confident they could afford the post-adjustment higher payments if they cannot refinance or sell.

NOTE: Fluctuations in the economy often determine whether certain types of the loans listed below are available. During times of slow housing markets and high foreclosure rates, some types of ARM loans listed below may not be available. This is because ARMs are riskier to the borrower and lender, and when the economy is slow, they become even more risky. Just like borrowers, lenders do not want to risk handling foreclosures.

Mortgages allowing interest-only payments
An interest-only option can be a feature of any type of loan; however, it is typically available only for a limited time, after which payments go up sharply. Paying only the interest enables you to make lower payments without increasing your loan balance. At the same time, however, the balance does not decrease and you do not build equity unless the home goes up in value. If the house value doesn’t go up, you may owe money if you sell. In most cases, you can make principal payments at any time during the interest-only period.

People who choose a mortgage allowing interest-only payments usually are those who plan to move (or less often, refinance) before the interest-only period ends; expect their income to increase sharply; receive large bonuses at certain times of the year; or reasonably expect the value of the house to rise sharply. They must budget wisely and be willing to make lump-sum payments, steering clear of using that money for other purposes. These borrowers must be confident that if they do remain in the home or cannot refinance, they could afford the higher monthly payments. At the end of the fixed period, you must refinance, pay a lump sum or start paying on the principal.

Loans with pre-payment penalties
A pre-payment penalty can be part of any type of loan, so you should check with the lender to find out whether the loan you want carries this type of penalty. However, loans with these penalties may offer initially lower payments in exchange for a promise to pay a specified lump sum if the borrower refinances the date specified in the mortgage agreement.
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