Before we start discussing which mortgage is right for you, we must understand the different types of loans available, how they work, and who they fit.
1. Conventional Fixed Loans
These loans are your most common loans, they can come in many term lengths ranging from 5-40 years and are the simplest to understand. You choose the length of time you want to repay the home in and then make equal monthly payments for that entire term. Your payment never changes, the interest rate is fixed and there are no surprises, simply a paid off loan by the term’s end. These loans are usually referred to by their term followed by the word “fixed” (30yr Fixed, 20yr Fixed, 10yr Fixed)
Who should get one: The typical home buyer that owns his primary residence and is looking for peace of mind, safety and predictability in their finances. The person that wishes to stay in their home 10+ years and plans to keep the home, not use it as an investment.
2. Adjustable Rate Mortgages
ARM (Adjustable Rate Mortgages) are a more complex breed of loans, they can be very effective and helpful but also very dangerous if not fully understood. ARM loans have fixed and variable terms, and are usually amortized over 30 years. So how does an ARM work? An ARM comes in two formats, annual, and semi-annual. It is usually represented in a fraction format such as 1/1, 3/1, 5/1, 7/1, 3/6, 5/6. The first number of the name is the fixed rate portion of the loan, the second number is the frequency of the rate change. Lets look at the 5/1 and the 3/6 as examples.
The 5/1 is an annual ARM, this can be quickly determined by the number 1 being the 2nd number, meaning the loan will adjust 1 time per year on it anniversary. The first number in this case a 5 represents the number of years that your interest rate and payment will remain fixed. So in this case the 5/1 ARM is a loan that stays fixed for 5 years and adjusts every year on its anniversary after that, and continues to do so till the 30 years in up.
The 3/6 is a semi-annual ARM because of the number 6, which indicates that the adjustment will take place every 6 months, therefore twice per year.
The first number like the example above signifies the number of years the payment will stay fixed for. ARM loans are usually available at a lower interest rate than the conventional loans (which make them attractive) and also carry much lower payments. The down fall of the ARM lies in the balloon payment that remains at the end of the loan. Unlike the conventional, you still owe a balance after you are done paying your 30 years worth of payments. You save monthly but pay a large portion of your loan at the end of it. This type of mortgage also exists with an interest only option that allows you to pay the interest portion of the payment each month and increases your final balloon payment to the original money owed. In other words you pay for your loan and pay no equity in-to your own house.
Who needs to get one: Individuals planning to leave in a home less than 5 years and need the flexibility of paying a lower payment and rate as they will be in a better position to pay in the next 3-5 years rather than now. The interest only option is really nice if you qualify for it as well, and a favorite among investors.
3. Negative Amortization Loans
A very popular loan back in the sub prime days, the NAL (Negative Amortization Loans) are much more dangerous than the ARM as it could make you loose your house in months.
Before I go into details as to what type of loan this is, and how it works; allow me to say this if you are offered such a loan and decide to take it, READ ALL THE FINE PRINT. These loans are known as cheater loans for a reason, simply because they are sneaky. NAL loans are complex and designed to allow people to get in home that are priced much higher than their monthly income allows. They are usually much lower in rates than both arms and conventional loans and offer monthly payments to dream for based on teaser rates. These loans are often advertised in teaser format (1.9% rates or $500,000 for $1000 a month)
The loan works in three steps:
1.The teaser part: This part of the loan is usually a very attractive rate or payment that stays fixed for a period of 6-12 months and allows the borrower to make very affordable payments on a not so affordable home.
2.The payment Option: Each month as you receive your bill, you are given the opportunity to pay 1 of 4 payments.
*Teaser payment: Minimal payment that is lower than the interest portion.
*Interest Only Option: The interest portion of your payment
*15yr fixed payment: Payment based on fixed rate and repayment of 15 yrs
*30yr fixed payment: Payment based on fixed rate and repayment of 30 yrs
These four options are available each time you get your loan stub but start disappearing as you keep opting to pay for the lowest of the four.
In other words, nothing is free. When you choose to pay the mininum payment (assume: $1000) and the interest only payment is (assume: $2100), the difference does not disappear from the books, instead it gets added to the principal balance of your house, so in this case you will now owe an additional $1100 for that month. Most people are unaware of this fact and simply believed that the lower payment was a favor from the bank to earn their business.
3.The Negative CAP: Often undisclosed, the negative cap was the limit that was set by the lender that allowed your negative equity to hit before payment options were reduced from 4 to 1. For example, the limit would be set to 5% by most lenders and so therefore whenever the principal balance of your loan would increase by 5%, (Example: $100,000 loan X 5%= $5000 meaning if you were to use the example above and paid $1000 instead of $2100…you would take the $5000 / $1100 = 4 monthly payments where you are allowed to pay the teaser payment and then surprise: $3500 a month based on the 30 yr fixed payment you were not told about and that you clearly cannot afford. Of course these numbers are simply created and do not reflect actual monthly payments but it gives you an idea of how quickly people went and were not able to help themselves.
These are the 3 elements that make the NAL the most complex loan on the market and the most dangerous one for those that do not understand it.
Who needs to get one: Very wealthy people who plan to purchase very expensive homes, have the means to afford them but don’t get paid monthly, but rather receive very large annual bonuses. This gives you the ability to pay a small amount on your monthly bill but allows you to make a large payment to eliminate the negative equity you build annually and remains in good standing with the lender, so therefore you can continue to use this method until the home is paid off using annual income, not monthly cash flow.
I hope that when you are ready to purchase a home you will take the time to understand the loan and options you are choosing on your mortgage. Making an educated decision can mean the difference between keeping and loosing your home in hard times. Despite what you read here and elsewhere, always ask questions when unclear and ask to see it in writing. Not all lenders are up front and honest about their loans, they sometimes do whats necessary to meet their quota or put you in a home, it is your job to ensure they are doing the right thing for you by knowing exactly what you are getting into.