In the past, the mortgage industry was quite conservative. There were limited options in front of the buyers however in the past couple of decades there has been a proliferation of different mortgage types. One of the main reasons is the diverse requirement from buyers. The private mortgage industry has launched a plethora of products to satisfy the needs of different buyers.
The different mortgage types available with a buyer are:
Fixed rate mortgage (FRM):
This is a basic and the most popular mortgage type. It allows the buyers to take a mortgage and pay interest according to a fixed rate. It is fully amortizing; that is both interest and principal payments are included within every payment. The payments remain same for the entire term which makes it easier for the buyer to budget the mortgage payments. There are different periods for which fixed mortgage is available: 10, 15, 20 or 30 years. Some mortgage terms allow longer periods also. This is an ideal option for buyers if the interest rates are low. Currently, most of the buyers are switching to fixed rate mortgage because of the rock bottom interest rates. However, if the interest rates are continuously falling this mortgage will end up causing higher payments. This is due to multiple refinancing of mortgage causing heavier expense by the household.
Adjustable rate mortgage (ARM):
This is the most popular alternative to fixed rate mortgage. The interest rate for this mortgage is adjusted according to an index. There are several indexes like LIBOR, COFI, MAT and CMT. All of them move according to a given pace depending on the ups and down in the economy. The lender adds their margin to the index and charges the interest rate. This type had gained huge traction during 80s, 90s and early 2000s because of the continuously falling interest rate. When interest rate fall in the index the final interest is automatically pushed down. This removes the need for costly refinancing.
The general ARMs available are 5/1 or 7/1. This means that the interest rate will remain fixed for five years, and then they will be adjusted every year according to the prevailing index rate. They have a lower interest rate than FRMs because the interest rate risk is passed to the buyer from the lender.
There are various kinds of ARMs:
Hybrid ARM: This is the most commonly used ARM. The interest rate remains fixed for a given period after which it adjusts according to the index it is using. General hybrid ARMs are 5/1, 7/1 or 10/1.
Option ARM: This mortgage provides the borrower greater options of how they want to pay the lender. The borrower can choose to have minimum initial payments or fully amortizing payments or amortizing after a given period. The biggest issue with this mortgage is that many borrowers get lured in by the low initial payments but see huge payment shock when the interest rate adjust, or the loan becomes amortizing. Ideally this is suitable for those borrowers who are savvy in their financial knowledge and have a good deal of financial discipline.
Cash Flow ARM: The biggest issue with households is that although their income varies their mortgage expense remains fixed. This makes it difficult to manage expenses during difficult times. Cash Flow ARM gives greater flexibility to households by fixing a minimum payment rate for a given period. The household can then carefully budget their expenses and pay the ideal amount and also save the maximum amount depending on their tax bracket.
Convertible ARMs: ARMs have an adjustable rate that passes the interest risk to the borrower. In order to shield oneself from huge hikes in interest rate, the household can take convertible ARM. Here it is possible for the borrower to convert an ARM into fixed rate mortgage. The lender charges a fee for switching, but the borrower can prevent paying higher interest rates by getting a fixed rate.
The various ARMs became very popular during a declining interest rate environment. Also, the ARMs will be given at a lower interest rate than fixed rate because the interest rate risk is carried by the borrower. When the difference in the interest rate available for FRMs and ARMs is high, the market share of ARMs increases instantly.
Figure: Market share of ARM in 90s and 2000s and comparison with the difference in the interest rate between FRM and ARM.
In the above figure, we can see that when the difference between the interest rates between FRM and ARM decrease to less than one percentage points the market share of ARM plummets instantly. Conversely, if the difference in interest rates is around two percentage points the demand for ARMs increases.
Federal Housing Administration (FHA) mortgages: The basic requirement when applying for a mortgage is to have decent credit score and put a down payment. Typically a credit score of 620 is the lowest any lender considers, and a down payment of 10% is required. During financially hard times, these requirements might further be tightened. In order to make it possible for a larger group of people to avail mortgages and have their own home FHA initiated its own program. Learn more about FHA mortgage rates.
According to this FHA, insures the mortgage that protects the lenders against any default by the buyer. The buyer has to pay an additional insurance premium and in return the buyer can avail mortgage at much lower down payment (minimum is 3.5%) and a lower credit score ( lower scores of 580 are also considered and in extenuating situation much lower credit scores are also provided mortgage).
Veteran Affairs (VA) Mortgage:
In 1944, President Roosevelt signed Servicemen’s Readjustment Act, which has given wide benefits to eligible veterans. One of the major benefits has been in availing mortgage. Over the history of this program, more than 20 million homes have been constructed using VA loan. The government does not provide the mortgage directly but insures the mortgage that a person gets from qualified lenders. The biggest benefit is that there is no down payment requirement. There is a funding fee of up to 3.3% that can be financed within the loan. Also, the Debt to Income (DTI) ratio can be up to 41%. There are certain restrictions in terms of the price of the house however it is a great asset for people who are qualified to apply for it.
Most of the mortgages within US are restricted in terms of purchasing price by Fannie Mae and Freddie Mac. For buyers who need to purchase house that are beyond this limit they have to look for jumbo mortgage. Even higher middle-class professionals are now seeking jumbo mortgages in high-cost areas like San Francisco and New York. The interest rate is a bit higher than the regular mortgage, and the credit score requirements are also more stringent.
Learn more about Jumbo Mortgage Rates Today.
We have a page dedicated exclusively to the HECM reverse mortgage rates.
This is a bit different mortgage because the payments are made by the lender to the borrower. The house is kept as collateral in this mortgage which is sold after the demise of the owners or when the owners leave the house. The amount recovered is used to pay for the mortgage (hence the term ‘Reverse’). The minimum age requirement is 62 years to avail this mortgage. It can be a great boon for retired couples and individuals to boost their household income or to use much-needed cash during emergencies. The majority of reverse mortgage are taken by Home Equity Conversion Mortgage (HECM), a program under FHA. They have certain restrictions in terms of price and certain requirements which need to be fulfilled by the owners. Needless to say that all the buyers should do adequate homework and do a proper analysis of their financial situation before using this program.
Balloon mortgage: Balloon mortgage is similar to fixed mortgage with the difference being that the entire remaining principal needs to be repaid at the end of the term. Usually, this term is 5 or 7 years. During this time, the borrower pays the interest and principal according to a 30-year term. At the end of the term, the borrower would need to either sell the house or refinance the mortgage to come up with the remaining principle. Generally it is preferred by buyers who are sure to leave the house within this term.
Piggyback mortgage: Every mortgage requires mortgage insurance till the loan to value ratio is not 80%. In order to circumvent this rule and to avoid paying extra insurance amount many borrowers get two mortgages. The down payment is 10%; primary mortgage is for 80% of the home value and the second mortgage or piggyback mortgage is for 10% that is availed through Home equity loan or HELOC. The overall usage of this mechanism is quite small with the usage being 3.8% of loans generated in 2012.
Graduated Payment Mortgage: One of the chief issues with mortgage is that when the mortgage is taken the payment remains fixed or moves according to external factors. This leaves little scope for the borrower to adjust the payments according to their earnings. Graduated payment mortgage allow the borrower to have low initial mortgage payment. This payment then increases annually according to a set percentage. This can be immensely helpful to younger borrowers as their income will increase as they gain experience, and they can easily pay the increased payments.
It is useful for older borrowers because the earnings of the household generally keep up with the inflation that is around 2-3%. Hence, an increase in payment of 2-3% can be easily accommodated by most of the households. FHA allows for 2.5, 5 or 7.5% of annual increase for the first five years or 2-3 % increase for the first 10 years. After this initial term, the payment get stabilized.
Note: The overall interest expense due to this mortgage is higher than simple fixed year mortgage for equal terms.
Rural Housing Service (RHS) mortgages:
RHS provides mortgage to low or medium income groups situated in rural areas. A rural area is classified as open country or a town with a population no more than 20,000. The various goals of this program is to provide easy finance for rural population, housing options for farm labor, helping developers to make multi- family housing projects and providing community facilities such as libraries, child care etc.
B/C mortgage: Many individuals have poor credit history. They might not qualify for a mortgage through conventional mortgages. For these individuals, subprime loans are available also called “B” or “C” class loan. These loans have much higher costs and interest rates than the prime loans. When this type of mortgage is taken as an ARM, it can snowball into a major crisis when interest rates increase.
Figure: Percent of delinquent mortgage in Texas, Source: Mortgage Bankers Association
The above figure clearly depicts the impact that the subprime mortgage had in Texas and throughout US. After the financial recession lenders have reduced their exposure to these loans.
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