Understanding Different Types of Loans Available
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Today's homebuyer has more financing
options than have ever been available before. There are so many loans to choose from and
this can be overwhelming for a buyer to
understand. From traditional mortgages to adjustable-rate and hybrid loans,
there are financing packages designed to meet the needs of virtually anyone
looking to buy a home. It may be confusing to know which loan and the terms
of the loan are right for you. So, I am always here to help you through the loan
process. With my experience being a loan officer, I will be able to help answer
any questions that you may have.
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While the different choices may seem
overwhelming at first, the overall goal is really quite simple: you want to find
a loan that fits both your current financial situation and your future plans.
Though this article discusses some of the more common loan types, you should
spend time talking with different lenders before deciding on the right loan for
your situation to make sure the loan is right for you. The more research you do,
the more you will learn and ensure you make the right decision.
General
categories of loans
Most loans fall into three major
categories: fixed-rate, adjustable-rate, and hybrid loans which combines features
of both. (Knowledge is the key to achieving the right loan)
Fixed-rate
mortgages
As the name implies, a fixed-rate mortgage carries the same interest rate for
the life of the loan. Traditionally, fixed-rate mortgages have been the most
popular choice among homeowners, because the fixed monthly payment is easy to
plan and budget for, and can help protect against inflation. Fixed-rate
mortgages are most common in 30-year and 15-year terms, but recently more
lenders have begun offering 20-year and 40-year loans. (Ask the lender to
explain the difference between the terms of each loan)
Adjustable-rate
mortgages (ARM)
Adjustable-rate mortgages differ from fixed-rate mortgages in that the interest
rate and monthly payment can change over the life of the loan. This is because
the interest rate for an ARM is tied to an index (such as Treasury Securities)
that may rise or fall over time. In order to protect against dramatic increases
in the rate, ARM loans usually have caps that limit the rate from rising above a
certain amount between adjustments (i.e. no more than 2 percent a year), as well
as a ceiling on how much the rate can go up during the life of the loan (i.e. no
more than 6 percent). With these protections and low introductory rates, ARM
loans have become the most widely accepted alternative to fixed-rate mortgages.
Plus, this type of loan has many advantages; this also depends on your situation
and goal.
Hybrid loans
Hybrid loans combine features of both fixed-rate and adjustable-rate
mortgages. Typically, a hybrid loan may start with a fixed-rate for a
certain length of time, and then later convert to an adjustable-rate
mortgage. However, be sure to check with your lender and find out how much
the rate may increase after the conversion, as some hybrid loans do not have
interest rate caps for the first adjustment period.
Other hybrid loans may start with a fixed interest rate for several
years, and then later change to another (usually higher) fixed interest rate for
the remainder of the loan term. Lenders frequently charge a lower introductory
interest rate for hybrid loans vs. a traditional fixed-rate mortgage, which
makes hybrid loans attractive to homeowners who desire the stability of a
fixed-rate, but only plan to stay in their properties for a short time. (i.e.
People in the service, relocating, etc.)
Balloon payments
A balloon payment refers to a loan that has a large, final payment due at the
end of the loan. For example, there are currently fixed-rate loans which allow
homeowners to make payments based on a 30-year loan, even though the entire
balance of the loan may be due (the balloon payment) after 5 or 7 years. As with
some hybrid loans, balloon loans may be attractive to homeowners who do not plan
to stay in their house more than a short period of time.
Time as a factor
in your loan choice
As has been discussed, the length of time you plan to own a property may have a
strong influence on the type of loan you choose. For example, if you plan to
stay in a home for 10 years or longer, a traditional fixed-rate mortgage may be
your best bet. But, if you plan on owning a home for a very short period (5 years
or less), then the low introductory rate of an adjustable-rate mortgage may make
the most financial sense. In general, ARMs have the lowest introductory interest
rates, followed by hybrid loans, and then traditional fixed-rate mortgages. This
is a very crucial point in choosing the right loan for your needs. The wrong
choice can have devastating consequence in the long run and cost you more money
than you think.
FHA and VA loans
U.S. government loan programs such as those of the Federal Housing Authority
(FHA) and Department of Veterans Affairs (VA) are designed to promote home
ownership for people who might not otherwise be able to qualify for a
conventional loan. Both FHA and VA loans have lower qualifying ratios than
conventional loans, and often require smaller or no down payments depending on
the program that you may choose. Ask your loan officer to explain the different
types of mortgages that you qualify for and the difference between them all.
This will ensure you get the right loan for your needs.
Bear in mind, that FHA and VA loans
are not issued by the government; rather, the loans are made by private lenders
but insured by the U.S. government in case the borrower defaults. Remember too,
that while any U.S. citizen may apply for a FHA loan, VA loans are only
available to veterans or their spouses and certain government employees. Ask
your lender for further information.
Conventional
loans
A conventional loan is simply a loan offered by a traditional private lender.
They may be fixed-rate, adjustable, hybrid, or other types. While conventional
loans may be harder to qualify for than government-backed loans, they often
require less paperwork and typically do not have a maximum allowable amount.
This loan also is used more when you do not qualify for FHA/VA loans.
Prepayment
Penalty on loans
There is a chance
that you may get a loan that may have a prepayment penalty. This is usually
in due to the borrowers credit score being below average. Most loans usually
have a 2 to 5 year prepayment penalty, make sure that you ask your lender if
you have one or not. You do not want to get to closing and find out that you
have one at the last minute. Also, make sure you check your loan documents,
they usually have a clause on the prepayment penalty that you have to sign.
When in doubt, always ask…
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15-Year, 30-Year,
or a Biweekly Mortgage? Which one?
In the past, the 30-year, fixed-rate
mortgage was the standard choice for most homebuyers. Today, however, lenders
offer a wide array of loan types in varying lengths--including 15, 20, 30 and
even 40-year mortgages. (Ask your lender for an amortization schedule for each
loan. You may be surprised to find out the difference.)
Deciding what length is best for you
should be based on several factors including: your purchasing power, your
anticipated future income, and how disciplined you want to be about paying off
the mortgage. Making the right choice now can prevent you from experiencing
financial problems later.
What are the
benefits of a shorter loan term?
Some homeowners choose
fixed-rate loans that are less than 30 years in order to save money by paying
less interest over the life of the loan. For example, a $100,000 loan at 8
percent interest comes with a monthly payment of around $734 (excluding taxes
and homeowner's insurance). Over 30 years, this adds up to $264,240. In other
words, over the life of the loan you would pay a whopping $164,240 just in
interest, ask your lender for an amortization schedule.
With a 15-year loan, however, the
monthly payments on the same loan would be approximately $956--for a total of
$172,080. The monthly payments are more than $200 more than they would be for a
30-year mortgage, but over the life of the loan you would save more than
$92,000.
Biweekly
mortgages
As the name implies, biweekly mortgage payments are made every two weeks instead
of once a month--which over a year works out to the equivalent of making one
extra monthly payment (compared to a traditional payment plan). One extra
payment a year may not sound like much, but it can really add up over time. In
fact, switching from a traditional payment plan to a biweekly mortgage can
actually shorten the term of a 30-year loan by several years and save you
thousands in interest.
If you're interested in a biweekly
payment plan, make sure to check with your lender. In many cases, most lenders
also offer direct payment services that automatically withdraw funds from your
bank account, saving you the trouble of having to write and mail a check every
two weeks. Also, they may offer a lower interest rate as well for signing up for
this program.
Making
extra payments yourself, it pays to do so!
Another way to pay off your loan more quickly is to simply
include extra funds with your monthly payment. Most lenders will allow you to
make extra payments towards the principal balance of your loan without penalty.
(Please check with your lender and mortgage note.) This is especially attractive
to homebuyers who are concerned about their future earning power, but still want
to be aggressive about paying off their loan and not being charged all that
interest.
For example, if you had a 30-year
loan, you might decide to send the equivalent of one or two extra payments a
year (which could shorten the overall length of the loan by many years). But if
your financial situation suddenly took a turn for the worse, you could always
fall back on the regular monthly payment and not be required to keep making
those extra payments.
One important note, though, is that
if you do decide to send extra funds, make sure to do it EARLY in the life of
the loan. This is because most home loans are calculated in such a way that the
first few years of payments are almost entirely interest, while the last few
years are mostly applied towards the principal balance. (Ask your loan officer
for an amortization schedule.) Thus, you can save the most money by making the
extra payments early in the life of the loan. Whether you make an additional
$30.00 per month or several hundred dollars per month, any amount that you pay
will help you save on interest and shorten the life of the loan.
When Should You Pay Points on a Loan
and Why?
When it comes to comparing
interest rates for a mortgage loan, homebuyers often have the option of choosing
a loan with a lower interest rate by paying points. A point is equal to 1
percent of the loan amount. For example, with a $100,000 loan, one point equals
$1,000. A $200,000 loan, one point equals $2000. Points are usually paid
out-of-pocket by the buyer at closing. Sometimes you can get the seller to pay
for them, it’s all in the negotiation.
Paying points may seem
attractive, because a lower interest rate means smaller monthly payments, but be
careful! Is paying points always a good idea? It may not be! The answer depends
on how long you plan to stay in the house and what your goals are in life. Look
at the example below:
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Chuck and Susan Brown are shopping for loan rates on a $150,000 home. Their
bank has offered them a 30-year loan at 8.5 percent with no points. This works out to a monthly payment
of $1,153.37.
However, another bank has also offered them a loan at
7.5 percent if they agree to pay 2 points (or $3,000). At this lower rate, their
monthly payment drops to $1048.82, or a savings of $104.55 per month.
By dividing the amount they paid for the points
($3,000) by the monthly savings ($104.55), we see that they will have to own the
house for 29 months (or just under 3 years) before they will start to see
savings as a result of paying points. If Chuck and Susan plan to stay in the
house for many years, then paying points could make good sense and save them
money in the long run. But if they see themselves moving to another house in the
near future, or relocating, they'd be better off paying the higher interest and
no points. So, if you have a choice in paying points or take a higher rate, check
the formula to see what the greatest benefit for you is. (Side Note: the
above example does not take into account the time value of money that may
increase/decrease, which would slightly lengthen the break-even time.) |
Can you deduct points
on your income taxes?
In the United States, one side benefit of paying points on a mortgage loan is
that they are fully tax deductible for the same tax year as your closing.
However, this does not apply to points paid for a refinance loan. Check with your
tax consultant for more information and further details. For refinances, the
IRS requires you to spread out the deduction over the life of the loan. For
example, if you paid $6,000 in points for a 30-year refinance loan, you can only
deduct 1/30 of the $6,000 each year for 30 years. If you pay off the loan early,
though, you can deduct the remaining amount that tax year. Make sure your tax
consultant is aware what you have paid. If you switch tax consultants down the
road, you will need to inform them of the points and which direction you have
taken to make sure you take full benefits of the tax deductions.
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