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Types of Mortgages

written by: Baby Rani•edited by: Donna Cosmato•updated: 7/6/2011

The types of mortgage loans which are conventional can be classified into three major categories. These are fixed rate mortgages, adjustable rate mortgages and the combination or hybrid type. A fourth variation, the balloon mortgage, is also discussed in this article.

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    Looking for the most appropriate mortgage can be a tricky business. This is not just simply looking for the mortgage offering the lowest interest rate at various payment terms. A mortgage proposal with an upfront offer of a lower interest rate may not be a good one in the long run depending on what your circumstances will be 5 years, ten years, or 15 years from now. In fact, taking out a mortgage may not even be appropriate for you if you are not expected to stay in the area for a longer period of time. This article provides you with the major types of mortgage loans in the market and their respective features. It also provides the profile of the borrower that would most likely benefit from each of these types of mortgages.

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    Fixed Rate Mortgages

    The fixed rate mortgage (FRM) loan, as the name implies, has a fixed interest rate and monthly mortgage payment for the entire period of the loan. It could be available in 40, 30, 25, 20, 15 and 10 years. Loans with shorter periods of payment are given lower rates. This simplest type of mortgage is also considered as the safest among all the types of mortgages. The fixed rate mortgage provides homeowners with a safety net from fluctuation in rates for the entire duration of the mortgage. They can then easily plan out their budget as the rate, and the monthly payments, will not change for the length of the mortgage. However, the fixed rate mortgage charges higher rates than the other types of mortgages so homeowners have to pay higher interest. During the instances when the rates go down, homeowners will also have to be charged with a closing cost, if they choose to pre-terminate their mortgage. The fixed rate mortgage is best for homeowners who plan to stay in the property for more than ten years and want total payment stability.

    The Good

    As the rates and duration of the loan is fixed for the whole life of the mortgage loan, it becomes easier for you to plan your expenses. And if you go in for lower payments and a lesser rate of interest mortgage, then your financial flexibility becomes greater.

    The Bad

    In a fixed rate mortgage you are at the risky end because when the rate of interest goes down, the decrease is not considered. This means that even if the rates decrease you end up paying higher interest.

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    Adjustable Rate Mortgages

    Adjustable rate mortgages (ARM), which are also known as variable loans, charge variable interest rates over the period of the loan. Accordingly, monthly payments are adjusted based on the prevailing interest rate using a standard index. These types of mortgages, with one year “fixed period,” are open to risks of adjustments every year on the anniversary of the loan. The upside, however, for this type of mortgage is that homeowners are charged lower rates than that of a fixed rate mortgage. Various types under the adjustable rate mortgage category, including option adjustable rate mortgage loans, come with payment cap protection limiting the amount that the monthly payment can be increased. The portion or amount of the interest that is not covered by the cap will then be added to the principal amount. This type of mortgage is appropriate for homeowners who otherwise would not be qualified for higher rate programs. Further, this is also the most appropriate mortgage for homeowners who want to take advantage of lower interest rates and are capable to absorb yearly adjustments of payments.

    The Good

    With an ARM your payments will decrease when the rates in the market fall. Also the initial rate is low compared to that of a FRM.

    The Bad

    You cannot have a stable payment as it changes with the passage of time. Also your payments will increase when market rates increases.

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    Hybrid Loans

    As the name implies, it is a combination of fixed and ARM loans. Hybrid loans come in different variations: fixed-period ARMS (30/3/1, 30/5/1, 30/7/1 and 30/10/1); 2-Step ARMs; and convertible ARMs. The general principle behind hybrid loans is that it attempts to combine the positive features of both the FRMs and the ARMs. It also provides a certain degree of flexibility for homeowners to take out certain options at specific periods of the loan term. These types of mortgages are appropriate for homeowners who are looking for initial payment stability. This specific variety is also a best fit for those who foresee possible resettlement during the term of the loan but could not qualify for the higher rate programs.

    The Good

    This type of loans takes into account all the pros of FRM and ARM.

    The Bad

    It might end up in negative amortization.

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    Balloon Mortgages

    Balloon mortgages are loans with a much shorter term and are basically a fixed-rate mortgage. Homeowners pay lower and fixed monthly payments for this short term mortgage. At the end of the term, the homeowner pays a lump sum, or a large balloon payment. This type of mortgage is most appropriate for homeowners who plan to live in the property for more than 5 years and are considering refinancing at the end of the term at prevailing market rates. This could also be a best option for homeowners who put premium to payment stability but are planning to move out of the property within 5 year.

    The Good

    Down payment in this type of mortgage is usually low when compared to other types of mortgages. Normally the interest rates are also low in a balloon mortgage.

    The Bad

    You will have to pay a large amount of money at the end of the loan period.

    References:

    http://www.mtgprofessor.com/fixed-rate_mortgages_(frms).htm

    http://homebuying.about.com/od/financingadvice/qt/0507loantypes.htm

    http://homebuying.about.com/od/financingadvice/qt/0507loantypes.htm