Understanding your loan options

Learn about the different types of loans available and the unique benefits associated with each one.

With so many different loans available, the process of finding one may seem overwhelming. The good news is that when you work with a reputable lender who can explain your options in easy-to-understand terms, you can customize your loan to provide the right fit for your financial situation.

Once you think through your goals and determine how much you can comfortably afford to pay each month, then it's time to select the loan type, term (length of loan), and fee structure that match your needs. Here are the major loan types to choose from:

Fixed-Rate Mortgages

This type of home loan tends to be the most popular, most likely because it protects homeowners from payment surprises and is easy to understand. With a fixed-rate mortgage, your interest rate—and your monthly payment of principal and interest—will stay the same for the entire term of the loan. You can work with your lender to set almost any term on a fixed-rate loan, but they are usually quoted as either 15 or 30 years.

Advantages

• Stability. You know exactly what you will be paying toward principal and interest every month for the entire length of the loan, which makes it easier to budget. (Though the amounts you pay for property taxes and homeowner's insurance may vary from year to year as these costs are not related to the loan terms.)
• If interest rates go up, you are protected. Your rate (and payment) will stay the same. Of course, if interest rates go down, your rate (and payment) will stay the same unless you decide to refinance.

When might a fixed-rate mortgage make sense?

• If you plan on living in your home for a long time (usually 7 years or more).
• If you have a monthly budget you need to stick to (that is, you do not feel financially prepared for possible increases) and require payment stability. Although taxes and insurance will be adjusted throughout the life of the loan, your monthly payment of principal and interest does not fluctuate
• If you are the kind of person who likes to know exactly what you will pay each month.

Adjustable-Rate Mortgage (ARM) or Hybrid ARM

Adjustable-rate mortgages have an interest rate that changes periodically according to fluctuations of an associated “index.” The interest rate is determined by adding together the rate of the index (which varies) with a margin (which remains fixed). The rate on the loan is adjusted periodically to bring the mortgage in line with the current index rate.

In practice, most lenders today offer a “hybrid ARM,” which is a combination of a fixed-rate mortgage and an adjustable-rate mortgage. These loans are named by the length of time the interest rate will remain fixed, typically from 1 to 7 years, and how often the loan adjusts thereafter. For example, in a 3/1 ARM, the 3 stands for a three-year introductory period in which the interest rate will remain fixed and the 1 shows that the loan is subject to adjustment once per year for the remainder of the loan term.

The rate on this kind of loan tends to be lower during the introductory period, which could mean a lower monthly payment. However, when the introductory period ends, the rate will go up or down and generally align itself with the prevailing market rate. That's why ARMs usually come with rate “caps” (or limits) to protect you from extreme fluctuations in your payments. There are two kinds of caps. Adjustment caps limit how much your rate can go up or down in any single adjustment period, thus limiting how much your loan payment can change when it adjusts. Lifetime caps establish a maximum interest rate over the entire life of a loan.

Advantage

• Hybrid ARMs generally offer lower introductory rates than fixed-rate loans, to compensate the borrower for the risk that the interest rate will go up after the introductory period ends.

Considerations

• After the initial fixed period, the rate is subject to adjustment. It's possible for the rate to increase at this point, which would also increase your payments. This can make budgeting for the future more difficult.
• If you choose this kind of loan, be sure it includes an adjustment cap and/or lifetime interest cap. Without caps, if you made only the minimum payments, your monthly payments may not cover all the interest due on the loan. The unpaid interest could then be added to the unpaid balance, and you could owe increasingly more than the original amount of the loan. This is called negative amortization.

When might a Hybrid ARM make sense?

• If you'll move before the fixed-rate introductory period expires and the mortgage rate becomes subject to adjustment. For example, a 5/1 ARM could work for someone who will move in four years.
• If you believe interest rates will go down in the future. This could be a major risk, so you should be confident that you can afford the monthly payment if the interest rate adjusts upwards to the maximum amount possible with this loan.

Interest-Only Mortgage (IO)

Interest-only mortgages start with monthly payments that include only the loan's accrued interest. After this initial period ends, however, the monthly home payments become amortized and can significantly increase. An amortized payment consists of partial payment towards the loan principal and partial payment of the interest charges, so that the loan will be paid-off by the end of a set term. In general, interest-only mortgages may be a good choice for a small number of buyers with special circumstances.

Advantages

• Paying just the interest charges on a loan allows buyers to make the smallest monthly payment possible. This is sometimes used as an affordability tactic by buyers in rapidly rising or high-priced markets.
• This type of loan may be a fit for buyers with fluctuating incomes, as long as they are disciplined enough to pay more than the minimum as often as they can.

Considerations

• Because your monthly payment only repays the interest accruing on this loan, the only equity you would own in your home would be the amount you paid as a down payment. Since your monthly payments do not reduce the loan principal, you would not build equity unless the market value of your house goes up. And if the value of the house were to decline, then you could lose part or all of your down payment.
• This kind of loan can be difficult to get, as it requires higher borrower qualifications.
• It's critical to know the highest possible monthly payment you may have to make on this loan, and for you to be confident you could pay it.

When does an IO loan make sense?

• If you're opting for lower payments to invest money into home renovations or remodeling, because you believe that these would increase the home's value and you could refinance or sell in the future.
• If you know you'll be moving before the interest-only payment term expires, and you don't need to access the equity (your down payment contribution) from the home in order to buy a new one.
• If the bulk of your income is paid in bonuses or commissions, an IO mortgage allows you to make small monthly payments and use large income distributions to periodically pay down principal.