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Mortgage
Terms Explained
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by:
Chris Cooper
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When
you are hunting for a mortgage, you will find that there are many
different types of mortgages available. I will list some of the more
common ones and their uses.
15 vs 30 Years
Your mortgage term can be just about anything you choose. 15 and 30
year terms are popular these days, although 10 and 20 years also are
available.
The shorter the term, the lower the interest rate. But the main
attraction of shorter term mortgages is the money you save.
For example on a $200,000 mortgage with a fixed 4.5% rate, you would
pay $1013.38 a month for 30 years and $1529.99 a month for 15 years.
Over 30 years you would pay $364,816.80 versus $275,398.20 over 15
years, a savings of $89,418.60 or 24.5% in interest.
If you cut a very conservative quarter of a percent off for reducing
the lender's exposure by 15 years, your savings will be nearly 26%.
Adjustable Rate Mortgages (ARM )
ARM’s are mortgages whose rates adjust according to the terms of the
contract you made with the lender.
Usually interest rates are fixed for the first 1, 3, 5, 7 or 10 years.
After that period is up, rates will be allowed to fluctuate within the
limits of your contract with the lender.
Terms are usually 15 or 30 years (although you can negotiate just about
any duration you want). There can be a balloon
involved.
Because the lender is not taking as big a risk on losing money if
interest rates rise, these loans will have a lower initial rate than a
fixed mortgage. The lowest rates will be for 1 year ARM’s and will go
up accordingly.
Many people will take out an ARM even in period of low rates, such as
now, because they get even lower rates and are able to afford more
house. However, the borrower is taking the risk that he can still
afford the house after the rates are free to rise.
It used to be common for the contract to limit fluctuations to 2% a
year. However, 5% swings are becoming more the norm. Depending on what
happens to interest rates, you might find yourself priced out of your
house. Of course, you could renegotiate if rates start to go back up.
The average homeowner owns his or her house for approximately 7 years.
If you plan to move before the initial fixed term of the ARM is up,
it’s a good choice. If you plan to stay longer than ten years, a fixed
rate might be a better option.
Balloon Mortgage
A balloon mortgage is one that is not completely paid off at the end of
its term.
For example, you might obtain a 15 year fixed rate mortgage that allows
you to pay less than the normal amortization schedule would call for.
At the end of the 15 years, you will still owe a portion of the
principal. How much depends on the terms of the contract.
An interest only mortgage is an example of this
type of loan. In the case of an interest only loan, the balloon will be
the full amount you originally borrowed.
This type of mortgage allows borrowers either to afford more house then
they otherwise could buy or its reduces their monthly costs, allowing
them to spend or invest their savings elsewhere.
Again, if you are planning to move before the balloon is due and your
proceeds from the sale are enough to cover the balloon, this might be a
good idea. However, you face the very real possibility of having to
come up with cash when you sell to cover the balloon, especially if you
have to sell at a time of declining housing prices.
BiWeekly Mortgages
A biweekly mortgage is one where pay half of the normal mortgage
payments every two weeks. Since you are making 26 payments a year,
rather than 24, you wind up paying off the interest sooner and saving
considerable interest.
Take the example of a $200,000, 4.5% fixed rate mortgage with a 30 year
term. The normal payment would be $1013.37 a month.
The biweekly amount is $506.91. But the payoff is huge. Your loan will
be paid 5 1/2 years earlier and you will save 28% or $32,639.75
interest.
You can set up your own biweekly mortgage plan with your existing
mortgage, assuming there is no prepayment penalty (which usually only
applies the first few years anyhow). Simply send in or have your bank
debit your checking account for one half your mortgage payments every
two weeks. There should be no extra costs or fees to do this.
Or you can reach a similiar result by dividing your monthly payment by
twelve and adding that to your payment. In this example that would come
out to be an extra $84.44 a month.
The secret is that any prepayment, no matter how small will result in
saving in interest and a shorter payment period.
Bridge Loans
Bridge loans are used in real estate transactions to cover the down
payment on a new home, when the borrower has equity in his old home,
but not enough cash.
It is generally a short term, interest only loan that is repaid when
the homeowner sells his old house.
Conventional Mortgage
Most mortgages are conventional, the terms just vary. A conventional
mortgage to most people is a 15 or 30 year fixed rate mortgage with at
least 20% down.
Construction Mortgages
These are really loans that carry a higher interest rate than a normal
mortgage. They allow you to borrow the money to build a house and are
converted into a mortgage once the house is finished.
FHA (Federal Housing Administration)
The FHA is a branch of the Housing and Urban Development (HUD)
Department. It is a depression era creation, meant to make it possible
for people to buy homes at a time when banks where not granting
mortgages.
The FHA insures loans up to certain set amounts, which vary with the
region of the country and the type of loan. Right now the guarantees
run from about $160,000 for a one family house to somewhat over
$300,000 for a four family home.
This type of mortgage is designed to help low and moderate income
people become home owners. It requires low down payments and has
flexible lending requirements.
If the borrower defaults, the government steps in and pays the
guarantee. This makes it easier for lenders to write mortgages they
would otherwise refuse.
Fixed Rate
Fixed rate mortgages have interest rates set for the term of the
mortgage, which can be anywhere between 5 to 30 years.
Although they can be interest only or have a balloon, they usually are
conventionally amortized mortgages.
At times like now, when rates are low, most homeowners want to lock in
the low fixed rates. They are popular when rates are falling, not so
popular when they’re high or going up.
This type mortgage is a very good idea if you're planning to live in
your house for a while.
Home Equity Line of Credit
A revolving credit line secured by your home. Because it is a mortgage,
it carries a lower rate than other forms of credit and is tax
deductible.
It differs from a second mortgage in that it is not for a fixed term or
amount and can be kept in effect as long as you own your home.
This is used most frequently for debt consolidation and can be useful
if you rip up your credit cards and use the money you save on interest
to invest.
Interest Only Mortgages
This is just what it says. You only pay interest, the principal is
never reduced.
This is the grand daddy of all balloon mortgages and you taking a big
risk that your house depreciates in value rather than the other way
around.
You could very well have to come up with extra cash at closing.
The payments are much lower than on a normally amortized mortgage and
if you have the discipline, it can be a useful financial planning tool.
Jumbo Mortgages
Mortgage loans over $322,700 (the limit is periodically raised).
Otherwise, the mortgage can be fixed or variable, balloon, etc.
Rates are usually a little higher than for smaller loans.
No Doc or Low Doc Mortgages
This refers to the mortgage application, not to the mortgage itself.
Business owners, people living off investments, salesmen and others
whose income is variable might use low or limited documentation
mortgages.
Very wealthy borrowers or those who want substantial financial privacy
will sometimes use the no doc option.
In either case, in spite of their names some documentation is required.
The lender will accept nothing less than excellent credit and even then
you will pay more for the privilege.
No Money Down Mortgages
These come in two flavors: FHA type loans that allow low or moderate
income borrowers to buy a house with little or nothing down and the
80-20 plans, where wealthier borrowers with little money saved up
finance 100% of the purchase price.
Under the 80-20 plan a first and second mortgage are issued
simultaneously. The borrower avoids having to buy mortgage insurance.
The two loans are designed to cost less than an 80% loan plus the
insurance, otherwise they make no sense.
If the borrower puts some money down, you will see the mortgage
referred to as 80-10-10 (the last digits will be the percent of down
payment) or some similar number.
It is mostly used by borrowers who haven’t saved enough for a down
payment or by those who have the money, but would rather use it for
other purposes.
Refinancing
This technically means getting a new mortgage at different, hopefully
better terms. A lot of people use it interchangeably with obtaining a
second mortgage or line of credit; in other words tapping into the
equity of their house.
Second Mortgages
Secondary financing obtained by a borrower.
They can be fixed in amount or take the form of a Home Equity
Line of Credit, which is simply a revolving credit line
secured by a house.
Homeowners use these forms of financing to consolidate bills, do home
renovations, put their kids through college, etc. They are tapping into
the equity they have in their house to use for other things.
This is not necessarily a great idea. You must take firm control of
your finances when you start doing this or you risk either losing your
house or having to raise cash to pay the mortgages off when you sell.
If done properly, you can pay off your debt at a lower, tax deductible
rate and invest your savings.
VA (Veteran’s Administration) Mortgages
The VA provides mortgage guarantees to active duty and ex-servicemen
who meet certain eligibility requirements. (To read the requirements click
here.)
Like with FHA loans, the government guarantee makes it easier for low
and moderate income veterans and active duty service personnel to
obtain mortgages.
The current VA guarantee is $89,912. It is raised periodically.
125% Mortgages
If you want to bet house prices will rise, some lenders will lend you
up to 125% of the value of your house. If you’re right, you’re okay.
Otherwise be prepared to have your checkbook available when you sell
your house.
I’m sure that there are other financing options available that I
haven’t covered and don’t even know about. But most of the main
financing types are covered here.
About the Author
Chris Cooper is a retired attorney who is very
familiar with debt, being in it too many times in his life. These
articles pass on some of the knowledge he has gained striving to become
debt free. He is editor-in-chief of http://www.credit-yourself.com a
website devoted to debt management
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