Mortgages are long-term loans that use real estate as collateral. Mortgages are typically used for buying one home but can serve as collateral for more than one mortgage.
When this is the case, the second mortgage is typically used to finance home improvements or another purchase such as a car or boat. Mortgages are defined by their terms, such as the time frame of repayment and whether the interest rate is fixed or adjustable.
Conventional mortgages are not insured or subsidized by the government. Most lenders require a downpayment of at least 20% on a conventional loan, but offer them with lower downpayments if the buyer purchases private mortgage insurance (PMI).
PMI protects the lender if the home owner defaults on the mortgage. Conventional mortgage loans are generally fully amortizing. This means that the regular principal and interest payment will pay off the loan in the number of payments stipulated on the note.
Mortgages are described by the length of time for repayment and whether the interest rate is fixed or adjustable. Most conventional mortgages have time frames of 15 to 30 years and may be either fixed-rate or adjustable.
While most mortgages require monthly payments of principal and interest, some offer bi-weekly payment options.
Home buyers who can afford the higher monthly payment sometimes prefer a 15-year conventional mortgage over a 30-year mortgage.
Interest rates on 15-year mortgages usually are a little lower than 30-year rates. In addition, a home buyer financing a home purchase with a 15-year mortgage will repay principal much faster and will pay far less interest over the life of the loan.
The 30-year fixed rate mortgage
With a 30-year fixed rate mortgage, the homebuyer pays off the principal and interest on the loan in 360 equal monthly payments. The monthly payment for principal and interest remains the same during the full loan period.
The 15-year fixed rate mortgage
The 15-year fixed-rate mortgage is paid off in 180 equal monthly payments over a 15-year-period. A 15-year mortgage typically requires larger monthly payments than a 30-year loan and allows an individual to pay off a mortgage in half the time as well as save on interest. For example, monthly principal and interest payments on a $100,000 mortgage at 7.25 percent interest are $682 when repaid over 30 years and $913 when repaid over 15 years. However, the buyer can save thousands of dollars on interest charges by using the 15-year mortgage. Fifteen-year mortgages typically carry interest rates a little lower than those for 30-year loans.
Adjustable rate mortgages
With a fixed-rate mortgage, the interest rate stays constant during the life of the loan. But with an ARM, the interest rate changes periodically, usually in relation to an index such as the national average mortgage rate or the Treasury Bill rate. Payments can go up or down accordingly.
Initial interest rates for ARMs are generally lower those for fixed-rate mortgages. This makes the ARM easier on your payments at first than a fixed-rate mortgage for the same amount. It also may help you qualify for a larger loan because lenders sometimes make this decision on the basis of your current income and the first year's payments. Moreover, an ARM could be less expensive over a period of time than a fixed-rate mortgage -- for example if interest rates remain steady or move down.
Against these advantages, you have to discern the risk that an increase in interest rates would lead to higher monthly payments in the future. It's a trade-off: you get a lower rate with an ARM in exchange for assuming more risk.
Here are some things to consider with an ARM:
Is your income likely to rise enough to cover higher mortgage payments if interest rates go up?
Will you be taking on other sizable debts, such as a car loan or school tuition, in the near future?
How long do you plan to own this home? (If you plan on selling soon, rising interest rates may not pose the problem they would if you plan to own the house for a long time.)
Can your payments increase even if interest rates generally do not increase?
What index is used to adjust the mortgage rate?
Try to obtain a table showing movements in the index over the past 10 years to see how your mortgage payments could change.
How often will the mortgage be adjusted? One year? Three years? The longer the adjustment period, the better you will be able to plan your future expenses.
What is the initial mortgage rate? Does it include a special discount? Is there an increase in your monthly payments when your rate is adjusted for the first time?
What is the margin on the interest rate? The margin is the amount that the lender adds to the index rate to calculate your mortgage rate. For instance, if the index rate is 6 percent and the margin is 2 percent, your overall interest rate would be 8 percent.
What limits or caps have been placed on the periodic adjustments? One of the most important items to discuss with your lender is the maximum amount that your rate can increase in any single adjustment period and over the life of the mortgage. Find out the "worst case" scenario in the event of a sharp increase in your index rate.
Can negative amortization occur? When negative amortization occurs, the monthly payments do not cover the full amount of principal and interest, so the amount of principal that you owe actually increases. Find out any limits there are on negative amortization.
Does the mortgage have a convertible feature? If so, is there a cost to convert? This option allows you to change your ARM to a fixed-rate loan at some designated time in the future.
Is there a prepayment penalty if you sell your house and pay off your loan early?
Other types of conventional mortgages
Balloon mortgages are a non-amortizing loan. In other words, the periodic principal and interest payments do not pay off the loan within the term. Some balloon mortgages may have a principal and interest payment that is calculated as if it would pay off the loan in 30 years, but the loan comes due in 5 or 7 years. Some lenders offer terms for renewal of the loan at the balloon date if certain conditions, such as a history of timely payment, are met. Some loans may contain provisions to be rewritten as a fixed- or adjustable-rate amortizing loans with the monthly principal and interest payment based on the balance remaining on the balloon payment date.
Bi-weekly mortgages provide a way for paying off a mortgage more quickly. With a bi-weekly mortgage, the borrower makes half the regular monthly payment every two weeks. Because there are 26 two-week periods in the year, the borrower makes the equivalent of 13 monthly payments each year. This allows borrowers to complete payment on a 30-year mortgage within 16 to 22 years. The lower the interest rate, the longer the term of the mortgage required for pay-off. To reduce the paperwork associated with the extra payments, lenders typically require that payments be deducted automatically from a borrower's checking account. Bi-weekly payments may be used with either 30-year or 15-year mortgages.
Some builders provide concessions to buy down interest rates for one to three years or for the term of the mortgage to help their buyers qualify for mortgages during periods of especially high interest rates. This allows lenders to maintain the necessary yield on the mortgage.
Shared equity loans treat the purchase of a home as an investment that can be split between a resident owner and an investment owner. The investment owner contributes a share of the downpayment, the monthly payments, or both, and proportionately shares in the ownership of the home. At resale, the borrower and the investor split the proceeds after repayment of the balance of the mortgage. Both buyers may also share the tax benefits, but the type and amount of tax deduction would depend on the type of agreement. Many lenders limit this kind of loan to immediate family members.
The Federal Housing Administration (FHA) operates several low downpayment mortgage insurance programs that homebuyers can use to purchase a home with a downpayment of 3 percent or less of the cost of the home. The most commonly used FHA program is the 203(b) program which provides for down payment assistance on one- to four-family homes. The maximum loan amount for a one-family home varies from $67,500 to $152,362 depending on local median prices.
FHA loans are available from most of the same lenders who offer conventional loans. Your loan officer can provide more details about FHA-insured mortgages and the maximum loan amount in the area you are looking.
If you are a veteran or active duty military personnel, you might be able to obtain a mortgage guaranteed by the Department of Veterans Affairs (VA). VA-guaranteed loans require little or no downpayment.
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