Types of Mortgages
Whether you are purchasing a new home or refinancing your existing one, it’s important to understand the basics of mortgages and the various types available.
20 % of all residential mortgages are insured or guaranteed by the federal government. Federal Housing Administration, or FHA, dates back to the Great Depression as a means to stimulate the housing market. It helps lower income earners obtain loans by issuing insurance to lenders against losses. The FHA approves lenders to participate in the program. The Department of Veteran’s Affairs, or VA, operates on a similar model to the FHA, it helps eligible service members and veterans to obtain a loan by insuring the lender against potential losses. A third type of government loan is the Farmers Home Administration, FmHA, which is designed for buyers in rural areas.
While government loans are attractive with lower interest and low or zero down payments, they do have their downsides such as lower maximum mortgage amounts and long approval and funding processes.
The remaining 80% are called conventional loans which can be either conforming or jumbo based on annual adjusted limits. Conventional loans within the limits are called conforming and those that exceed the limits are non-conforming, or jumbo, loans. Jumbo loans mean a greater risk to the lender so the down payment percentage is increased and interest rates are generally higher.
Mortgages terms can be either short term (less than 30 years) or long term (30 years or longer). A 15 year loan will have higher payments than a 30 year loan but will have a lower interest rate.
A mortgage has two basic parts, principal and interest. Principal is the portion of your payment that goes towards reducing the amount owed to the lender. Interest is the fee you pay the lender for the privilege of using their money. The interest rate on mortgages can be either fixed, adjustable or interest only. On a fixed rate mortgage, you will pay the same interest rate for the term of the loan. Adjustable interest rates go up and down depending on market conditions. Interest only loans are unique in that you pay the interest on the loan but no principal.
When shopping for a mortgage, you will be looking at current interest rates as well as points. A point is equal to 1% of the loan amount. For example, on a $100,000 loan, one point equals $1000. Points come in two flavors, discount points and origination points. Discount points are fees that you pay upfront to reduce the interest rate. These points are actually pre-paid interest and are tax deductible. A buyer can pay from zero to three or four points depending on how much they want to reduce the interest rate. A no-points loan will have a higher interest rate than a loan with 1 or 2 discount points.
Origination points are not tax deductible and do not serve to reduce the interest rate. Instead, they are charges by the lender to either cover the costs of the loan or to boost their profit.
Lenders review potential borrowers’ creditworthiness before issuing any type of loan. This is called qualifying. First, they check the credit report to make sure the borrower has a credit history that shows their integrity in meeting their financial obligations. Next, they look at income and job stability. Finally they look at the debt to income ratio. How much debt does the borrower carry? Does he make enough to handle the debt, other expenses and the new mortgage?
Lenders also look at the value of the property being purchased by ordering an appraisal. They want to see the loan to value ratio to determine how risky the loan is. They calculate the loan to value ratio by taking the loan amount divided by the property’s appraised value. The more money the borrower puts down, the lower the loan to value ratio becomes reducing the lender’s risk.
Lenders typically require enough cash reserves to cover two to three months of living expenses in the event of an emergency. For those borrowers with a higher loan to value ratio, lenders may require private mortgage insurance, or PMI. PMI protects the lender not the borrower and is a tool to help borrowers into a home with a lower down payment. PMI is charged monthly as part of the house payment. As home equity builds, it may eventually be removed.
Another type of mortgage is the reverse mortgage. This mortgage is commonly used when equity in the home has grown significantly and the borrower needs income such as in retirement. The reverse mortgage allows the borrower to receive monthly payments from the lender. The lender then adds interest to the loan balance. The interest is paid back after the home is sold. Reverse mortgages are available to free and clear homeowners over the age of 62 who live in the home as a primary residence.
Determining the right mix of interest rate, points, length of loan, fixed, adjustable or interest only is complex and depends largely on the situation of the borrower. What may be right for one family will be wrong for another. One borrower may intend to sell the house within a year or two while the other may intend to live there for years to come. Be sure to consider and communicate your goals, lifestyle as well as your budget when shopping for a loan.
