By Holger Reinel | Updated on January 17, 2020
When buying a home, most homebuyers accept the first mortgage offered to them by their lender. Why?
Because they don’t know what types of mortgage loans are available to them and the pros and cons of each. The fact is, there might be a better option waiting for you; one that could make you save thousands in interests and fees.
When I bought my first house, for instance, I did not know much about mortgages; so I went with a fixed rate, 5-year closed mortgage. It sounded simple and predictable. What I did not know is that there are variables that should be taken into account such as
That was a starter home, so three years after, I bought a new home, but had to pay three months’ interest as a penalty for breaking the 5-year mortgage term. That was an expensive lesson; as you can see, there are times that a fixed-rate mortgage can be a good option and there are times when it can be a bad one.
Keep reading to learn about the most common types of mortgage loans, pros, and cons, and which mortgage type suits you best.
What are the different types of Mortgage Available in 2019?
There are different types of mortgages available to home buyers. Let’s take a look at the pros and cons of each option, so you can make an informed decision when getting your mortgage.
Conventional Mortgage vs. High Ratio Mortgage
The difference between a conventional and a high ratio mortgage is the size of the down payment.
A conventional mortgage is a loan for no more than 80% of the home’s purchase price; the remaining 20% comes from your down payment. Lenders view this type of mortgage as low risk because of the higher equity the homebuyer invests. With a conventional mortgage, you are not required to obtain mortgage default insurance.
Pros of a conventional mortgage
Cons of a conventional mortgage
Right for If you can give at least a 20% down payment, you should get a conventional mortgage so that you don’t have to pay those hefty mortgage insurance fees.
Also, a variable rate is more adequate for home buyers that plan to stay in the home for less than 5 years.
A high ratio mortgage is when you borrow more than 80% of the purchase price. Many home buyers have a down payment of 5% and the lender fund the remaining 95%; this is a high ratio mortgage.
Mortgage insurance, also known as PMI, is mandatory for homebuyers who have a down payment lower than 20% of the purchase price, and it is designed to protect lenders in case the borrower defaults on their payments.
Many people wonder, if mortgage insurance protects the lender why does the home buyer have to pay? You’re compensating the lender for taking the higher risk of lending to you vs. lending to someone with a larger down payment.
Pros of a high-ratio mortgage
Cons of a high-ratio mortgage
Right for homebuyers who have a down payment of less than 20% of the home’s purchase price.
Fixed-Rate Mortgage vs. Variable Rate Mortgage
When it comes to the interest rate, you’ll have the option to choose between two structures; one where the interest rate stays the same for the entire mortgage term (Fixed Rate Mortgage), and one where rates could go up or down as market conditions change (Variable Rate Mortgage).
There are valid reasons for each either of these two options.
The fixed-rate mortgage is the most favored by home buyers because of the security and peace of mind of locking an interest rate for the entire term of the loan. This means you’ll know what the exact mortgage payment will be for the duration of the mortgage term.
Pros of fixed-rate mortgages:
Cons of fixed-rate mortgages:
A fixed-rate mortgage is better for homebuyers that are working on a tight budget. The fixed-rate offers them the stability of knowing the exact amount of the mortgage payments now and well into the future.
The interest rate with a variable or adjustable-rate mortgage is lower than with a fixed-rate mortgage; however, beware that if rates rise, your mortgage payments will increase as well.
Variable-rate mortgages are not right for every borrower; many homebuyers find this type of mortgage appealing because they can qualify for a more expensive home.
Pros of a variable-rate mortgage:
Cons of a variable-rate mortgage:
A variable-rate mortgage might be right for borrowers that have budgetary flexibility and who are comfortable with a certain level of risk could benefit by choosing the variable rate option.
An adjustable-rate mortgage or ARM is a type of mortgage where the initial rate is fixed for a short time after which the rate starts changing, but without a precise formula that defines what the new rate could be.
Pros of an adjustable-rate mortgage:
Cons of an adjustable-rate mortgage:
Right for no one. In my personal opinion, ARMs mortgages can be too risky and hard to understand for most homebuyers. Keep away from any mortgages that sound like body parts, (ARMs).
A hybrid mortgage lets you split the total of the amount you are borrowing into two or more amounts with each being subject to a different interest rate and different terms.
The most common split is a 50/50 split with one part having a fixed rate, and the other half having a variable rate.
The goal of a hybrid mortgage is to reduce the borrower’s exposure to changes in the interest rate. For instance, if rates rise, then only half of the entire mortgage amount is affected.
Pros of a hybrid mortgage:
Cons of a hybrid mortgage:
Right for any home homebuyer who is torn between deciding for either a fixed rate or a variable rate. Also, a hybrid mortgage can be an excellent vehicle to limit a homeowner’s exposure to interest rate changes.
Many home buyers with less than 20% down payment use a combination mortgage loan to avoid paying mortgage insurance (PMI).
For example, a home buyer can take out a mortgage for 80% of the home’s value and an additional 20% of the home’s value all with the same lender. The first loan would have a standard, low-interest rate, and the second loan a much higher rate.
Pros of a combination mortgage:
Cons of a combination mortgage:
Right for any homebuyer who can handle responsibly both loans at the same time.
In addition to deciding whether you want a fixed rate or a variable rate, you also have to decide if you want an open mortgage or a closed mortgage.
An open mortgage gives you the ultimate flexibility of being able to pay off the loan in full at any time during the mortgage term without penalty. To compensate for that flexibility, the interest rate on open mortgages is typically higher than on closed mortgages.
Pros of an open mortgage:
Cons of an open mortgage:
Right for homebuyers who anticipate receiving a lump sum of money that would allow them to pay off their mortgage early without being locked into a long term contract.
A closed mortgage is a mortgage where you can make regular payments according to the terms, but you cannot pay the loan off during the term. If you do so, such as when if you sell the home before the term is up, you will pay a hefty penalty for breaking the mortgage agreement.
Pros of a closed mortgage:
Cons of a closed mortgage:
Right for homebuyers who anticipate staying in the home for at least five years, or who don’t plan to pay off the loan in full for the same time frame.
A portable mortgage is a mortgage loan that allows the borrower to transfer the balance of their existing mortgage to another property without incurring penalties or having to re-apply.
For example, if you have an existing mortgage at a very good rate, but you are in the process of selling your home and will be buying another property, with a portable mortgage, you can port out or transfer your mortgage to the new property.
You won’t have to pay penalties for breaking the mortgage contract, and you get to keep the interest rate of loan the same.
Pros of a portable mortgage:
Cons of a portable mortgage:
Right for any homebuyers who may need to sell their existing home before the mortgage term comes for renewal.
Also known as gap loans, a bridge mortgage is a type of short term loan buyers can get to fund the purchase of another home while they are selling their existing home.
This is a popular type of mortgage loan used by home buyers who intend to use the funds from the sale of their existing home as part of the down payment for another property.
Pros of a bridge mortgage:
Cons of a bridge mortgage:
Right for homebuyers who have excellent credit history and who have enough equity in their existing property to cover at least 20% of the purchase price of the new property.
An interest-only mortgage is a mortgage loan where the borrower pays only the interest for part or the full length of the term. Thus, despite how many payments you make, you will always owe the same balance because your payments only cover the interest.
However, this type of mortgage loan allows borrowers to pay only the interest for an initial term which typically can be the first five or ten years. After that time, the mortgage payment increases to cover both the principal and the interest.
For example, a 30-year mortgage might allow a borrower to pay only the interest for the first 5 years, and starting on year 6 through to year 30, payments will have to cover both the principal and interest portion.
Pros of an interest-only mortgage:
Cons of an interest-only mortgage:
Right for first-time homebuyers or for buyers whose income fluctuates such as people who earn commission vs. a flat salary.
A collateral mortgage is a type of mortgage that is re-advance-able meaning the lender can loan you more money as you gain more equity in the home.
Pros of a collateral mortgage:
Cons of a collateral mortgage:
Right for homebuyers with stable finances who plan to stay in the home for a long time (at least 5 years).
A balloon mortgage is a type of loan where you make regular small payments with a large payoff, known as a balloon payment, due at the end of the loan.
This type of mortgage loan typically has a short term, around 10 years, but could be even shorter.
Although balloon mortgages are more common in the commercial real estate industry, they could apply to homebuyers expecting their income to increase significantly over the next few years or where a borrower anticipates re-selling the home in the short term.
After you purchase a home, you may need extra cash to pay for things such as renovations, moving, furniture, or simply to create an emergency fund.
With a cash-back mortgage, your lender advances you a lump sum of money after the mortgage closes. The amount can be 1% of the mortgage amount but can go as high as 7% of the mortgage amount.
An assumable mortgage is a type of mortgage where the amount outstanding on a loan is transferred from the current owner to the buyer. If the existing loan has a low-interest rate, this can be a cost-effective option for the new buyer who is assuming the loan.
If you’re looking to assume someone’s mortgage, you will need to be approved by the existing lender before the loan can be transferred to your name.
Assumable mortgages have fallen in popularity in recent years because of dropping interest rates, but in times when interest rates rise, an assumable mortgage can add value to both the buyer and the seller.
A blanket mortgage is a loan used to finance the purchase of two or more pieces of real estate. A homeowner can apply for a blanket mortgage using the equity of their existing home to finance the purchase of an additional home.
One area where this type of mortgage has gained popularity is with mortgage-free parents who use the equity of their homes as collateral to finance the purchase of a home their children want to purchase.
Also, if the equity of the two homes is more than 80% the value of the new home, the new home can be purchased without the children having to come up with a down payment and would not have to pay for expensive mortgage insurance.
The mortgage term refers to the time (in years) that you commit for. The term will have a direct effect on both your mortgage rate and your monthly payment.
The longer the term is, the lower your monthly payment. The most common mortgage term is 25 years, but other popular terms include 30 years and 20 years.
A 20-year mortgage means you will be on track to pay off the home fast but to do that the monthly payment would be larger than a 25-year or a 30-year mortgage.
The key is to understand the type of home you can afford without straining your finances or quality of life. For example, if the maximum you can afford is a $1,000,000 home, you should buy a one that’s worth no more than $800,000.
Because this way you’re not putting undue pressure on your finances.
While the government is not a lender, it does play a significant role in the housing market. In the USA, for instance, three government institutions back loans: the Federal Housing Administration (FHA loans), the U.S. Department of Agriculture (USDA loans), and the U.S. Department of Veteran Affairs (VA loans).
With the FHA program, you can get a mortgage with as little as 3.5% down payment and this type of mortgage is available to all borrowers, not just first-time home buyers.
To fund the program the government insures the loans for losses that might arise from defaulting borrowers. Advantages: You can buy a home with as little as 3.5% down payment. Disadvantages: You will have to pay an additional monthly mortgage insurance amount which increases your overall borrowing costs and monthly payments.
USDA mortgages help lower-income borrowers get mortgages to buy homes located in rural areas. The two main qualification conditions are the home must be located in a USDA-eligible area and the borrower’s income level. If you qualify, you could buy a home with no down payment at all.
An advantage of USDA mortgages is that you can buy a home with no down payment, but you’ll be limited to properties located only in certain areas.
VA mortgage loans are a great option for members of the U.S. military to buy homes (active members and veterans). VA mortgages are very flexible, low-interest loans that require no down payment, no mortgage insurance, and closing costs are capped making it the best option to buy a home if you are or have been a member of the U.S. military.
The biggest advantage of VA loans is that borrowers can get 100% financing to purchase a home and you don’t even have to pay for mortgage insurance. You will have to pay a small funding fee (1% – 3.3% of the home’s price) depending on your military status, whether it’s your first home financed with a VA loan.
Before you start shopping for a home, make an appointment with a mortgage agent so you can begin to understand your options as well as the type of mortgage that would best serve your housing needs.
Then go back and read this article again to reinforce your knowledge of the pros and cons of each mortgage loan while focusing on the option that gives you the best mortgage rate.
The type of mortgage you choose is an important aspect of the home buying process. Most homebuyers don’t realize this, but there are many options to choose from.
For borrowers with stable finances who can tolerate some risk and can afford rate fluctuations, the lowest variable rate in the market will typically yield the best results.
On the other hand, if you’re working with a tight budget, you’ll need predictability, which means a fixed rate or a hybrid mortgage type are worth considering.
In both cases, you’ll need to understand your current and future financial situation so that you can choose a mortgage type that best serves your needs now, and for years to come.
To learn more about mortgages, the home buying process, and step-by-step instructions on how to select the right mortgage check out our Home Buyer’s Online Course.
This is an interactive course designed in an easy to understand format; you will learn the eight stages of buying a home so that you can navigate the home buying process with confidence.
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