Lesson Mortgage Basics & Types of Mortgages

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An Introduction to Mortgages

A mortgage is a loan taken to finance the purchase of a house or real estate. This loan is usually obtained from banks, mortgage companies, or other private sellers. The home and/or land is kept as collateral for the loan, which means that the lender has a legal claim over it in case of default of loan. In a mortgage agreement, the lender is known as the mortgagee and the debtor or borrower, also as mortgagor. Sometimes, a third party, like a mortgage broker (who helps find the best deals) or a lawyer (to decide on legalities of the agreement) may also be involved.

Since the amount borrowed in case of mortgages are high, their repayment periods are long- usually 15-30 years. The repayment period is known as the term of the mortgage. By the end of this period, the borrower has to completely return the principal amount borrowed plus interest, by making periodical payments. This is called amortization. The amount of interest paid is determined by the rate of interest that the lender charges for letting you use his money.

Borrowers may also choose to pay back one mortgage completely before the term ends, and take out another mortgage. This is to make use of lower rates, accumulated value of the house etc. This is known as refinancing.

Types of Mortgages

Mortgages are of many types. Some major categories have been discussed below:

1)Fixed-rate mortgages (FRM): in which the rate of interest on the loan remains fixed for the entire term of the loan. These are the most popular kind of mortgages. The advantage with FRMs is that the periodic payments are predictable and are not swayed by changing market rates. Thus, it is easier for the borrower to make his budget. However, interest rates for FRMs typically tend to be higher to cover the risk of a higher market rate for the lender.

2)Adjustable-Rate Mortgages (ARM): in which the interest rate can move up or down to match current market interest rates. The rate is adjusted once every 1,3,5,7 etc years as agreed between the parties. The initial rate in an ARM is slightly discounted than market rates. ARMs are attractive to borrowers if market rates go down, resulting in lower payments for the borrower. Also, with an ARM, you often qualify for a higher loan amount. However, if the borrower is unable to predict the trend in market rates properly, he may end up paying more than in an FRM. An ARM is useful if the borrower plans to sell his house before interest rates rise.

3)Interest-Only Mortgages (IOM): in which the borrower only pays interest (plus property taxes and homeowners insurance) on the loan. The borrower thus has to pay a lower monthly mortgage payment and might also qualify for a higher loan amount. This type of mortgage is suitable for borrowers expecting the value of their house to increase in the next few years, after which the house will be sold. In that case, the borrower realizes more equity on sale than the loan he has taken.

4)Balloon Loans: in which the loan is not amortized or only partially amortized and the loan is repaid in one or a few large payments due at longer periods. Sometimes, balloon loans have a conversion option, by which the balloon loan can be converted to a new loan at the end of the first payment. Though the absence of periodical payments is an attractive option, borrowers face the risk of default if they are unable to make the complete payment due to high interest rates at the end of the period.

5)Sub-prime mortgages: these are loans for borrowers with a credit rating below 620. The low credit rating may be a result of past defaults or delays in bill payments, loan repayments etc. Lenders charge a higher rate of interest on such loans to account for the credit risk of borrowers. The agreement usually also include pre-payment penalty (if the borrower refinances with a lower rate loan) and balloon payments.

6)Jumbo mortgages: these are loans which let the borrower borrow more than that set by government limits. Hence, these come under ‘non-conforming’ loans. A higher interest rate is charged to compensate for the lender’s higher risk.

7)Two-step mortgage: which combine the features of FRM and ARM. Borrowers pay a fixed rate for an initial period, after which the rate is adjusted, and the borrowers continue to pay the new fixed rate for the remainder of the term. For example, a 5/25 loan thus has an initial foxed period of 5 years, and then 25 years of payment at the revised rate. this kind of mortgage provides good opportunity for borrowers who are confident of improving their credit rating in few years.

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