What are the Common Types of Home Mortgage Loans?

Once you have decided in favor of buying a home rather than renting one, the next choice you must make is where to obtain the mortgage loan and the type of mortgage best suited for your situation. With the ever-increasing complexity and variety in mortgage options, it is easy to be overwhelmed.

The following should provide a brief overview of the most common types of home mortgage loans and how each of them works over the long run.

4 Common Types of Mortgage Loans

1. Fixed-Rate Mortgage Loan

Historically, fixed-rate mortgages are the most common types of home loans issued, with nearly 90% of homebuyers choosing a fixed-rate loan. The term for these mortgages typically runs 30 years, with 10, 15, and 20-year term lengths as well. Fixed-rate mortgages offer consistent monthly payments, at a reasonable level, due to their extended repayment period. Consumers are content knowing the payment will be roughly the same year after year regardless of variations in interest rates.

15 Versus 30-Year Fixed-Rate Loans

A decision many homebuyers will ponder when approaching a fixed-rate home mortgage loan is the term length. Should I choose a 15 or 30-yr home loan? The argument is often made to show how much interest will be saved with a 15-year mortgage versus a 30-year loan; however, that should not be the only deciding factor.

Overall, most people prefer the 30-year mortgage option. This is due to the flexibility it provides by way of a lower monthly payment. With a 15-year mortgage, the total interest paid is much less over the length of the loan because the monthly payments are significantly higher. Signing on to this term is forcing the borrower to meet these higher payments each month, and that can be a challenge for some.

On the other hand, if one were to elect the 30-year mortgage, nothing in the agreement is usually stopping them from paying more than their minimum payment each month. This can speed up repayment of the loan as fast as the shorter-term option. Borrowers can make higher payments and reap many of the benefits of a 15-yr mortgage loan without a higher monthly mortgage payment obligation.

The main potential downsides of obtaining a 30-year loan and paying it off faster are that the initial interest rate is typically a little lower on a 15-year mortgage loan and there may be prepayment penalties for paying it off early.

2. Adjustable-Rate Mortgages (ARMs)

The next most popular type of mortgage loan is the adjustable-rate mortgage, often referred to as an ARM. With an ARM, the interest rate and the corresponding monthly payment change in sync with changes in the overall market interest rates. These changes could be tied to various indexes; however, the most common is the current yield on 1-year US Treasury bonds.

ARMs usually begin with a fixed-rate period, where the rate offered is below interest rates on traditional fixed-rate mortgages. This lower rate, often called a teaser rate, can attract many borrowers looking for the lowest monthly payment. After this fixed-rate period expires, the rate adjusts in correlation to current interest rates on a specific index. The most common length of the initial fixed-rate period is 5 years, with rate adjustments coming every 1 year after. This would be described as a 5/1 ARM.

Although the initial interest rate on an ARM may be lower than a conventional fixed-rate loan, there are caveats. If the interest rates rise dramatically, the borrower could be left with loan payments more than double their original amount. This sharp increase is difficult to budget for and has led to many foreclosures in the past.

If you want to pursue an ARM, be fully aware of the possible increases, and be prepared to come up with additional funds each month. Be sure to talk to a qualified mortgage lender to fully discuss the pros and cons of an adjustable-rate mortgage loan.

3. Interest-Only Mortgage Loans

Interest-only mortgage loans, when used for residential lending, are typically bi-products of adjustable-rate home mortgages. Many of the facts of an ARM hold, but during the fixed-rate period, the borrower is only required to pay the interest on the loan. Once this period is up, the rate adjusts to the market rate, and the amortization (pay down) is accelerated to make up for the period of no principal being paid.

Interest-only home mortgage loans, while most common in commercial settings, are sometimes used by high-income individuals with significant variations in their monthly incomes, such as a commission-based real estate salesperson. They can be used in certain scenarios to the borrower’s benefit, but most borrowers prefer an ARM or a fixed-rate loan.

4. Subprime Mortgages

Subprime mortgage loans are typically issued to borrowers who have recent or ongoing credit issues. Although each lender’s limit varies, many use a credit score of below 670 as the qualifying level at which a loan will be subprime. Using the low credit score of the borrower as an indication of risk to the lender, the rates will be higher on subprime mortgages than the aforementioned options.

While traditional mortgages tend to be very similar in terms and rates across lenders, subprime loans can vary widely depending on the specific credit situation of the borrower in question. For this reason, consumers looking into subprime home mortgage loans for real estate purchases would be even more prudent to attain quotes from various companies as the payments and terms could be drastically different.

Final Thoughts on the Different Types of Home Loans

Generally speaking, a 30-year conventional, FHA, USDA, or VA home mortgage loan is going to be a smart move.

If you only plan on being in your home for a short amount of time, then an ARM or interest-only loan could work for you. Especially if you think the value of the property you’re buying will rise quickly. Sub-prime mortgages are for home buyers with lower credit scores that have a solid income and are looking to also achieve the American dream.