As a homebuyer today, you have more home loan options available to you now than anytime in history. From traditional fixed-rate mortgages to adjustable-rate mortgages, government backed loans to hybrid loans, there are a wide assortment of mortgages designed to meet just about any borrower’s needs. Even if you have little or no money for a down payment, or your credit history is not the best, many lenders offer loan products that can help you achieve the American dream of home ownership.

Different Types of Home Loans

With many home loan choices available to you, it all may seem overwhelming to you and you may wonder where to begin. In this article, we are going to help you understand some of the choices you have available to you.

Your overall goal when considering a home loan is to find a loan that best fits your current financial situation and your anticipated future plans. Most mortgages fall into three basic categories: fixed-rate loans, adjustable-rate loans and hybrid loans.

Fixed-Rate Mortgages

A fixed-rate mortgage carries the same interest rate through the life of the loan; i.e., the interest rate does not change during the loan term. Traditionally, these have been the most popular choice for home loans among borrowers. Fixed-rate mortgages assure you of a constant monthly payment over the life of the loan (not considering taxes and insurance, which may cause payments to rise and fall over the life of the loan as either of these costs increases or decreases), making your planning and budgeting easier, and they can help to protect you against inflation.

The most common fixed-rate mortgages are the 30-year and the 15-year. However, many lenders are now offering 20-year and 40-year options.

Adjustable-Rate Mortgages

An adjustable-rate mortgage (ARM) differs from a fixed-rate mortgage in that the interest rate can change over the life of the loan, through periodic adjustments (for example, once a year, twice a year, etc.), thereby changing the monthly payment. The interest rate for an ARM is generally tied to some type of index (for example, Treasury Securities), which may rise and fall with time. The actual interest rate you pay on an ARM is computed by adding a margin (expressed in percentage points) to the index rate. The margin typically remains constant over the life of the loan; it is the index that moves up or down causing the interest rate to fluctuate. For example, let’s presume you are considering an ARM that is tied to the Treasury Index, and at the time of you obtaining the loan, this index is at 4.5 percent. If the margin for the ARM is 2 percent, your starting interest rate would be 6.5 percent (4.5% index + 2% margin).

To protect you against dramatic increases in the interest rate, most ARMs have a cap as to how much a rate can increase at the time of adjustment. For example, a 2% cap means the rate cannot adjust more than 2% at each adjustment. There is also a ceiling on how much a rate can increase over the life of the loan. For example, a 5% ceiling means the rate cannot increase more than 5% over the life of the loan. So, continuing with our example above, if the start rate is 6.5 percent, the cap 2 percent and the ceiling 5 percent, then the maximum your loan rate can increase (or decrease) at the first adjustment would be to 8.5 percent. The highest your interest rate could ever increase to under this scenario would be 11.5 percent.

Because of their low start rates, ARMs have become a very popular alternative to fixed-rate mortgages. By starting off with a lower interest rate, you may qualify for more home, and the lower payment in the beginning may be more beneficial for your current and future financial positions. For example, you may be starting your career and expecting to advance over the next several years, leading to increased future income; therefore, the lower introductory payment typically offered by an ARM may suit your current financial position, while possible future increases in your rate (and ultimately your monthly payment) can be handled by the expected increases in your income as your career advances.

Hybrid Mortgages

A hybrid mortgage combines the features of both the fixed-rate and adjustable-rate mortgages. Typically, a hybrid loan may start with a fixed-rate of interest for a specified length of time and then convert to an adjustable interest rate. An example of this type of hybrid mortgage would be a 5-1 ARM (3-1 and 7-1 ARMS are also common). Under a 5-1 ARM, the interest rate remains fixed for the first five years of the loan and then becomes adjustable after the fifth year. These types of loans have become very popular because they offer similar advantages of a conventional ARM, without the potential fluctuation in interest rate (and monthly payment) for the first five years of the loan. However, be sure to discuss with your lender how much of a rate increase you can expect after the conversion (fifth year in our example). Some hybrid loans do not have a cap for the first adjustment period.

Other, less common, hybrid loans may start with a fixed-rate of interest for a specified period of time and then convert to another (usually higher) fixed-rate for the remainder of the loan.

Another hybrid mortgage is the Balloon Payment Loan. Under this type of loan, the payments are amortized over 30 years (payments are set based on a 30-year mortgage), typically at a fixed-rate of interest, with the entire loan balance due and payable (hence, the name balloon payment) at some time prior to the 30 years. For example, a 7 year balloon payment refers to a loan that is amortized over 30 years, with the balance due and payable at the end of the seventh year.

Hybrid mortgages have become an attractive alternative to homebuyers who desire the stability of a fixed-rate, but only plan to stay in their home for a few years.

Choosing The Right Loan For You

When considering which type of loan would best suit your needs, you need to consider the length of time you plan on staying in your home. For example, if you plan to stay in your home for ten years or longer, a fixed-rate mortgage may be your best choice. If you only plan on staying in your home for five years, then a ARM or hybrid loan may be more suitable to your needs.

Typically ARMs have the lowest introductory rate (while presenting the most upside risk), followed by hybrids and then the fixed-rate mortgages. Each of these loans can be a fantastic option in the right situation. We highly recommend you consider your options carefully (discuss your options with your lender and/or accountant or tax advisor), to insure you make the best choice for your current and future financial position.

Conventional Loans

A conventional loan is a loan offered by a traditional private lender (for example, a bank, credit union, investor, etc.), and can be a fixed-rate, adjustable-rate or hybrid loan. Typically, conventional loans are slightly more difficult to qualify for than government-backed loans. However, they generally require less paperwork, offer a slightly lower interest rate and have a much higher maximum allowable limit.

Government Backed Loans

The U.S. government offers loan programs to assist homebuyers who might not otherwise qualify for a conventional loan, because of their qualifying ratios, credit history and/or lack of funds available for down payment. The Federal Housing Authority (FHA) and the Department of Veteran Affairs (VA) are two of the agencies who offer these types of loan programs. Bear in mind though, FHA and VA loans are not issued by the government; they are issued by private lenders and insured by the government against borrower default.

FHA loans require the borrower to put 3 percent of his/her own funds towards the down payment and/or closing costs. The remainder of funds can come from the seller or be gifted by a family, friend or organization. Any U.S. citizen can apply for an FHA loan.  For more information on FHA loans, Click Here to visit the Department of Housing and Urban Development's (HUD) website.

VA loans typically require a zero down payment from the borrower. However, the borrower must be a qualified veteran (or spouse of a veteran) with a valid veteran’s certificate. The borrower may be required to pay a portion of some of the closing costs.  For more information on VA loans, Click Here to visit the Department of Veteran's Affairs (VA) website.

Both FHA and VA loans carry a slightly higher interest rate (usually 1/8 – ¼ higher) than a conventional loan and both have limits as to the amount that can be borrowed.

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