My wife and I recently started looking at homes, and one of the topics we have discussed is the type of mortgage we want to get when we buy our new home. We thought our biggest decision would be choosing between a 15 Year and 30 Year Mortgage – that is, until we saw the wide variety of mortgage options available. The good news is you can usually find VA Loans to cover most mortgage options.
Types of Mortgages
There are many different types of mortgages, from fixed rate to interest-only to adjustable rate or balloon mortgages. Here are some advantages and disadvantages of each type of mortgage so you can make a more informed choice for the type of mortgage you want.
Fixed rate mortgage (FRM)
The interest rate on a fixed rate mortgage remains the same throughout the entire term of the loan. The amount of your monthly payment with an FRM is calculated using the interest rate and it’s compounding frequency, the term of the mortgage (15 years, 30 years, etc), and the total amount borrowed. See some of the other factors that affect your mortgage rates, and how to find a low mortgage rate.
The biggest benefit of a fixed rate mortgage is that you always know how much your monthly payment will be. The only time your fixed rate mortgage payment would fluctuate is if you also had your property taxes and property insurance handled in escrow and those amounts were adjusted.
The disadvantage of fixed rate mortgages is that if the interest rates are lower than what you locked into your mortgage, you could end up paying a higher interest rate than you needed to.
Adjustable rate mortgage (ARM)
Interest rates change with adjustable rate mortgages based on changes in constant-maturity Treasury securities, London Interbank Offered Rate, and the Cost of Funds Index. Because the interest rate changes over time, the amount the borrower pays on an ARM can change as well.
An adjustable rate mortgage helps share some of the interest rate risks with the lender. If the rates decrease, you’ll be able to take advantage of the lower interest rate, where as with a fixed rate mortgage, unless you refinance you’re stuck with the higher rate you had when you got the loan.
Of course, the disadvantage is if the interest rates increase, you could end up paying much more than you would have if you locked in the rate with a fixed rate mortgage before the rates increased.
Interest only mortgage
For a specific period of time, borrowers pay just the interest owed on interest only mortgages. During that period of time, the principal balance doesn’t change. The loan is usually set up with five or ten years for making interest-only payments, followed by amortization of the remaining balance over the remaining life of the loan.
The advantage of an interest only mortgage is that for the five or ten years that you pay interest only, the payments are substantially lower. It’s ideal for the individual who expects a salary increase by the time the mortgage starts charging principal payments. The disadvantage is you don’t make a dent in the principal for the first few years.
Mortgages which are not completely amortized over the term of the mortgage will end with a larger balance (the balloon payment) due upon maturity. Balloon mortgages are most often used for commercial real estate, and may feature a fixed or floating interest rate.
A balloon mortgage might make sense for people or businesses who plan to sell the property before they reach the large balloon payment; or for those who know they’ll have the money to pay the large payment when it comes due.
The problem with balloon mortgages is that many people reach the end of the term and don’t have the financial resources available to pay for the large balloon payment. Sometimes a “two-step” or “reset option” is used with balloon mortgages, which means the mortgage resets before the balloon payment is due using the current market rates to amortize the remaining balance.
Which type of mortgage is best?
Each of these types of mortgages offers advantages and disadvantages, but in my opinion, the best option is the plain-vanilla, no thrills, fixed rate mortgage. It may be boring, but right now mortgage rates are near all time lows and locking in low rates for the next 15-30 years is a great way to go. The remaining options have too many variables to be a good option for most individuals.