Understanding Different Types of Loans
Today's homebuyer has more financing options than ever before. From traditional mortgages to adjustable-rate and hybrid loans, there are financing packages designed to meet the needs of virtually anyone.
While the different choices may seem overwhelming at first, the overall goal is simple: To find a loan that fits both your current financial situation and your future plans. Though this article discusses some of the more common loan types, you should spend time talking with different lenders before deciding on the right loan for you.
General categories of loans
Most loans fall into 3 major categories: fixed-rate, adjustable-rate, and hybrid loans.
- Fixed-rate mortgages
A fixed-rate mortgage carries the same interest rate for the life of the loan. Traditionally, fixed-rate mortgages have been the most popular choice among homeowners, because the fixed monthly payment is easy to plan and budget for, and can help protect against inflation. Fixed-rate mortgages are most common in 30-year and 15-year terms, but are now offered as 20-year and 40-year loans as well.
- Adjustable-rate mortgages (ARM)
Adjustable-rate mortgages carry an interest rate and monthly payment can change over the life of the loan. This is because the interest rate for an ARM is tied to an index (such as Treasury Securities) that may rise or fall over time. In order to protect against dramatic rate increases, ARM loans usually have caps that limit the rate from rising above a certain amount between adjustments (i.e. no more than 2 percent a year), as well as a ceiling on how much the rate can rise during the life of the loan (i.e. no more than 6 percent). With these protections and low introductory rates, ARM loans have become the most widely accepted alternative to fixed-rate mortgages.
- Hybrid loans
Hybrid loans combine features of both fixed-rate and adjustable-rate mortgages. Typically, a hybrid loan begins with a fixed-rate, then later converts to an adjustable-rate mortgage. However, be sure to check with your lender and find out how much the rate may increase after the conversion, as some hybrid loans do not have interest rate caps for the first adjustment period.
Other hybrid loans may start with a fixed interest rate, then change to a new fixed rate (usually higher) for the remainder of the loan term. Lenders frequently charge a lower introductory interest rate for hybrid loans vs. a traditional fixed-rate mortgage. Hybrid loans can be attractive to homeowners who desire fixed-rate stability, but only plan to own their properties for a short time.
A balloon payment loans have a large, final payment due at the end of the loan. For example, some fixed-rate loans allow homeowners to make payments based on a 30-year loan, though the balance of the loan may be due (the balloon payment) after 7 years. As with some hybrid loans, balloon loans may be attractive to homeowners who plan to own their homes for a short time.
Time as a factor in your loan choice
The length of time you plan to own may have a strong influence on the type of loan you choose. For example, if you plan to own a home for 10 years or more, a traditional fixed-rate mortgage may be your best bet. But if you plan on owning a home for 5 years or less, the low introductory rate of an adjustable-rate mortgage may make the most financial sense. In general, ARMs have the lowest introductory rates, followed by hybrid loans, and then traditional fixed-rate mortgages.
FHA and VA loans
U.S. government loan programs through the Federal Housing Authority (FHA) and Department of Veterans Affairs (VA) are designed to promote home ownership for those who might not otherwise qualify for a conventional loan. Both FHA and VA loans have lower qualifying ratios than conventional loans, and often require smaller or no down payments.
Bear in mind, however, that FHA and VA loans are not government issued, but are actually through private lenders. FHA loans are insured to the actual lender and any U.S citizen may apply. VA loans are guaranteed in case the borrower defaults, but are only available to veterans, their spouses and certain government employees.
A conventional loan is simply a loan offered by a traditional private lender. They may be fixed-rate, adjustable, hybrid or other types. While conventional loans may be harder to qualify for than government-backed loans, they often require less paperwork and typically do not have a maximum allowable amount.