Types of Mortgages and Mortgage Terms

Study Notes

Mortgages

Mortgages are loans used by homeowners to finance the purchase of property. They come with various terms and conditions depending on factors such as property value, borrower's credit score, employment status, and income. There is a range of different types of mortgages available, each with its own set of features.

Types of Mortgages

Fixed-Rate Mortgages

Fixed-rate mortgages offer stability because you have a constant rate over the life of your loan. These mortgages are commonly known as traditional mortgages. They can last between 5, 10, 15, 20, and even 30 years. A fixed rate is beneficial when interest rates are low, providing a stable monthly payment throughout the term of the loan. However, if interest rates decrease after getting a fixed-rate mortgage, there would be no opportunity to refinance into a lower mortgage rate.

Adjustable Rate Mortgages (ARMs)

Adjustable-rate mortgages (ARMs) feature variable interest rates based on prevailing market conditions. For example, a common ARM might start with a fixed rate for three, five, seven or ten years before adjusting each year thereafter according to prevailing indexes such as LIBOR or the prime rate. After the introductory period ends, most ARMs will continue to reset every year until maturity. Understanding how these loans work is key for successful navigation of the housing market.

The initial period during which the interest rate remains constant is called 'the introductory period'. This period typically ranges from one to ten years. During this time, payments on borrowed money accrue, meaning they increase, despite consumers paying the same amount. Once the introductory period ends, the mortgage lender may change the interest rate based on market trends.

There are several options within the category of adjustable rate mortgages, including, but not limited to:

One-Year ARM

A One Year Arm has the lowest cap. As such, it does not move out of line with other short-term mortgages like those offered by alternative lenders. If interest rates rise significantly, the borrower risks having their payment skyrocket at the end of the first-year introductory period.

Three-Year ARM

In comparison to one-year arms, three-year ARMs are more popular due to their relatively cheaper cost. With a three-year ARM, borrowers get the benefit of low upfront costs and reduced monthly payments for much longer periods than they could with a one-year ARM.

Five-Year ARM

Five-year ARMs may have caps built into them. These caps ensure payments do not move too far out of alignment with other market norms. That said, they still carry higher risk compared to fixed-rate mortgages, especially when considering the possibility of rising interest rates.

Seven-Year ARM

Seven-year ARMs offer a balance between manageability and flexibility. Borrowers pay a lower interest rate than they would with a five-year ARM and enjoy extended protection against interest-rate resets.

Ten-Year ARM

Ten-year ARMs are less popular compared to shorter-term adjustable mortgages. Their main advantage lies in the fact that they offer the longest protection against rate resets. However, this does not guarantee that borrowers will not face higher payments, especially if interest rates increase dramatically.

15-Year Fixed or 15-Year ARM

Fifteen-year fixed mortgages are essentially a type of adjustable-rate mortgage where the initial interest rate is set for the entire term of the loan. The main difference between this and a typical fixed rate mortgage is that the interest rate adjusts annually to match the prevailing market conditions. This means that the borrower's payment will change every year depending on the prevailing market conditions.

Mortgage Terms

Down Payment

A down payment is the initial portion of the purchase price of a property that is paid in cash. It serves as a portion of the home loan's principal, which is the amount of money borrowed to buy a property, and is a percentage of the home's purchase price.

Interest Rate

An interest rate is the cost of borrowing money, expressed as a percentage of the amount borrowed. In the case of mortgages, the interest rate is applied to the outstanding balance of the loan until it is fully paid off.

Loan-to-Value (LTV) Ratio

The loan-to-value ratio (LTV) refers to the relationship between the amount of the mortgage and the value of the property. It is calculated by dividing the mortgage amount by the property's value.

Mortgage Insurance

Mortgage insurance is a type of insurance policy that protects the lender, not the homeowner. It is typically required by lenders when the borrower has less than a 20% down payment on the property's purchase price. The cost of mortgage insurance can be added to your monthly mortgage payment.

Closing Costs

Closing costs are fees and expenses that are due upon completion of a real estate transaction. They include charges for things like loan origination, discount points, appraisals, title searches, surveys, and credit reports. The buyer typically pays closing costs, although there may be some variation depending on the area and specific mortgage program involved.

In summary, mortgages come in different types, each with its own features and benefits. Understanding these differences, along with key terms such as down payments, interest rates, LTV ratios, mortgage insurance, and closing costs, is crucial for making informed decisions about mortgage financing.

Description

Explore the various types of mortgages including Fixed-Rate Mortgages and Adjustable Rate Mortgages (ARMs), along with key mortgage terms like down payment, interest rate, LTV ratio, mortgage insurance, and closing costs. Learn about the differences between these mortgage options and essential terms to make informed decisions in mortgage financing.