Chapter Nine: Types of Mortgages
Once you are ready to secure a loan, you must decide what type of mortgage is right for you. Consider the following:
 Type of down payment you make;
 Amount of time to pay the loan back, also known as the loan term;
 How long you plan to stay in the space;
 Interest rate you want to pay; and
 Other factors specific to your situation.
Although you'll be presented with a smorgasbord of choices, most mortgages fall into two primary categories:
 FixedRate Mortgages: Locks in your interest rate for the loan's lifespan. Your monthly payment is allocated to both the principal and interest, and usually remains constant. At the beginning of the loan, most of your monthly payment will go towards the interest. With each payment, more and more funds go to the principal. For residential properties, loans are readily available in 15 and 30year terms. Loans for commercial spaces usually do not exceed 15year terms; five and 10year terms are common.
 AdjustableRate Mortgages (ARM): The main difference between fixedrate and ARMs involves paying interest on the loan. Interest rates for ARMs generally start lower than on fixedrate loans, so borrowers may qualify for a higher mortgage amount. Because interest rates on ARMs fluctuate throughout the life of the loan based on financial market indicators, your monthly mortgage payment will also increase and decrease on a regular cycle. ARM loans are also available in loan terms as short as 15 years or as long as 30 years.
There are two basic ways mortgage lenders charge you for using their money: through interest charges you pay each month over the life of the loan, and points.
Points are an upfront fee based on a percentage of the loan. One point represents 1% of the mortgage. For example, for a $150,000 mortgage, one point
would be $1,500, or 1% of the mortgage; two points represents 2% of the mortgage, or $3,000; and so on.
Points can be paid as part of closing costs, or the lender will reduce the available loan proceeds by the amount of the points. Some loans will not
charge points, but will have a higher interest rate. In Washington State, most residential mortgages do not charge points.
When reviewing different mortgage products, compare their interest rates, points amounts and other fees to get a clearer picture of how much you will pay. The remainder of this chapter will discuss available loans.
Banking Terms
Key words for this chapter include:
 Amortization: The elimination of mortgage debt through regular payments over a specific length of time. Payments must be large enough to cover the principal and interest.
 Debt Ratio: A comparison between your total assets (gross income, money in the bank, equity in property, etc.) and total debts (credit cards, student loans, car loans, etc.).
 Deed: The legal document that transfers title of the property to the lender.
 Earnest Money: The funds you (the buyer) deposit with the seller to indicate serious interest in purchasing the space.
 Escrow: An account set up for you by the lender. Funds for your insurance and property taxes are held there until payments are required. The lender typically makes the payments for these expenses from this account.
 Equity: T he difference between what you owe on the property (the mortgage) and what the property is actually worth. For example, you purchase a home for $115,000. Five years later, the property's value increases to $125,000, but you still owe $75,000 on your mortgage. The difference between the value of the property and the mortgage amount you owe is $50,000 ($125,000  $75,000). You now have $50,000 in equity in the property.
 Interest Rate: The amount of money charged by the lender for using its money to purchase property. Is based on the risk of the loan and prevailing market rates.
 Lien: A legal claim against the property, used to secure loans; they must be paid first if the building is sold. Types of liens: property taxes, Internal Revenue Serviceissued, courtordered, etc.
 Mortgage: A type of loan specifically used to finance the purchase of real estate. Several types are available.
 Mortgagee: The bank, credit union or other financial institution that loans money to purchase real estate.
 Mortgagor: The borrower who accepts the loan from the lender.
 Principal: The original amount of money borrowed for the mortgage. Does not include the interest rate.
 Term: The length of time the borrower has to repay the principal with interest. Depending on the type of loan you choose, the longest mortgage term for residential properties is typically 30 years.
 Title: The legal document that denotes ownership of real estate.
Other terms and definitions will be defined as we go along.
You can access several superglossaries of terms and definitions fromDictionary.com,Investor Words,Global Investor Glossary or ADVFN Financial Glossary.
For real estate terminology, visit the Real Estate Agent.com glossary.
FixedRate Mortgages
Many options are available to you if you pursue a fixedrate mortgage. This section defines the characteristics of each mortgage product, and discusses pros and cons.
Conventional Residential
Guidelines for standard conventional loans include:
 Minimum 5% down payment
 Maximum property debt ratio of 28%
 Maximum total debt ratio of 36%
 Private Mortgage Insurance (PMI); required if down payment is less than 20%
 Two months' payment reserves for hazard insurance are typically required if insurance is paid through the lender via an escrow account
 Housing and total debt ratios may be expanded for specialty programs
 PMI can be avoided by taking out a second mortgage or line of credit to cover the down payment. These additional loans will usually have a higher interest.
LongTerm Residential
The most common longterm mortgages last 20 or 30 years.
Pros
The major benefits of these loans are their predictability, stability and length. You know exactly how much interest you will pay over the term, and
your monthly payments are allocated to both the principal and interest. In early years, the majority of the payment goes to interest, which is
taxdeductible. If the mortgage does not have a prepayment penalty, you can make extra payments to shorten the loan term. By making additional payments
against the principal, you ultimately lower the cost by reducing the total amount of interest you are charged.
Cons
Stability comes at a price. Interest rates on fixedrate loans are usually higher than those starting rates on adjustablerate loans. Downpayment
requirements on conventional, fixedrate loans can be as high as 10% to 20%. If you opt for a lower down payment, you might have to pay for mortgage
insurance, which can cost hundreds of dollars more per month. Mortgage insurance protects the lender in the event you are unable to continue loan
payments.
15year FixedRate
This is a shorter version of the traditional 30year fixedrate loan.
Pros
Again, stability and predictability are considerable benefits. In addition, you pay down the principal relatively faster when compared to longerterm
loans of 20 or 30 years. The 15year fixedrate loan lets you own your space debtfree in half the time, and for less than half the total interest cost
of a 30year fixedrate loan. Interest rates are usually lower than those offered on 30year fixedrate loans. Governmentbacked loan programs such as
the VA Loan may also have 15year programs.
Cons
Higher monthly payments make these loans more difficult to qualify for than longerterm mortgages. This limits the number (and cost) of properties you
can afford to buy. In addition, your monthly payments can be roughly 1530% higher than payments you would make with a 30year loan. If you are
considering a commercial property, this is the longest loan term you can expect.
Convertible FixedRate
Pros
Sometimes called a Reduction Option Loan (ROL), this loan combines the features and benefits of a fixedrate mortgage with an adjustablerate mortgage.
ROL loans allow you to pay a fixed payment for a certain amount of years, then revert to an adjustable mortgage payment schedule. The amount of time
you are allowed to make fixed payments is outlined in your mortgage contract. For more information on how adjustablemortgage payment schedules work,
see the section on AdjustableRate Mortgages. If you choose this loan product, include a
clause in your mortgage agreement that allows you to convert the loan permanently to a fixedrate mortgage, especially if interest rates begin
climbing. Typically, lenders will allow you to exercise this option between the 1359th payments (years 25), especially if interest rates fall at
least two percentage points below the initial interest rate your loan started with during that period.
Cons
The loan agreement might require you to pay an upfront fee to exercise your option to convert the loan permanently to a fixedrate mortgage. In
addition, interest rates for these loans are sometimes higher than on other ARM loans. While these loans give more buying power than a traditional
30year fixed rate mortgage (i.e., a lower interest rate means you can take out a higher loan amount), if rates increase to a high level and fail to
come down, this type of mortgage could end up costing you more in the long run.
Balloon Mortgage
Pros
This is a fixedrate mortgage with a twist: It has regular monthly payments like a traditional mortgage, but requires large lumpsum payments (the
balloon) at regularly scheduled intervals throughout the loan's term. Usually, these lump sum payments are required at the three, five, seven, 10 or
15year anniversary of the loan. Balloon mortgages typically offer a lower initial interest rate compared to 30year fixed rate mortgages, so
borrowers may qualify for a higher mortgage amount. At the end of the loan period, the borrower must then pay off the remaining balance on the loan or
refinance it into another loan product.
Cons
When a lumpsum payment is due, you might have to pay off the remaining balance of the loan all at once. In this scenario, if you have a high loan
amount, but a short term, you might have to pay an amount nearly equal to or more than what you have already paid on the loan. If you choose to
refinance the remaining balance, you run the risk of not remaining eligible for another loan. Even if you can refinance the remaining balance, the
majority of your monthly payments will initially go towards interest, and you will lose any equity you had in the property.
Biweekly FixedRate
Pros
This type of loan shortens the payment term of a 30year fixedrate mortgage by making 26 biweekly payments in a year instead of 12 monthly payments.
The biweekly payments are usually half the amount you pay when you make monthly payments. For example, if you pay $600 once per month on a monthly
payment cycle, your biweekly payments become $300. These extra payments can reduce the length of a 30year term to 1822 years. However, if the
biweekly payment schedule becomes too much, you can usually convert it to a conventional 30year fixedrate loan. Because the term is reduced, you pay
less interest over the life of the loan. In order to participate in this program, payments must be automatically withdrawn from your savings or
checking accounts.
Cons
While this program has advantages, payments must be deducted from a savings or checking account; this can be problematic if you do not have an account,
or if your income is erratic. In addition, the lender may make debit charges to your account. By paying off the loan faster, you lose the benefit of
deducting the mortgage interest from your federal taxes for as long as you would for a 30year fixedrate loan.
Construction/ Permanent Loans
Loan programs assist borrowers who want to build new properties. Construction loans are available, as well as a combination construction/permanent
option that features a single closing.
The loan would be secured by a mortgage on the land and the property, once it is built. The construction loan usually has a short term (1224 months)
to allow time to complete the building, and might then convert to a permanent mortgage on the completed property. With such loans, one has to decide
whether to incur the additional risk of building a space.
FHA Mortgage
Pros
The Federal Housing Administration (FHA), established in 1934, is the oldest and largest insurer of residential mortgage loans in the U.S. An FHA loan
offers lower down payment loans for qualified borrowers when compared to a conventional loan. Both fixed and adjustable rate mortgage products are
available, and usually only require a minimum cash investment of 3%.
FHA loans will also accept funds from gifts, other loans, and grants from select sources to be used for down payments and closing costs. Unlike
conventional loans, the maximum property debt ratio is increased to 29% compared to the 28% allowed for conventional loans, and the total debt ratio
can be as high as 41% versus 36%. While a conventional loan might require you to have at least a twomonth payment reserve (money in the bank to cover
the mortgage and/or insurance), this is not a requirement for FHA loans.
Cons
These loans have both income caps and limits on the mortgage amounts. Certain down payment assistance programs paired with government loans might also
feature income caps.
40year FixedRate
Pros
This is a standard fixedrate loan with a 40year term. The loan term allows you to have lower monthly payments: For example, $100,000 at 5% interest
with $0 down would be $537 with a 30year fixedrate loan, versus $482 with a 40year loan. In addition, it might allow you to secure a higher loan
amount and still have a manageable payment. Utilizing the above example, the payment on an $110,000, 40year loan at 5% would equal $530, which is
comparable to the $537/month payment on a $100,000 30year fixedrate mortgage at 5%. Another upside to these loans is that because Fannie Mae has
begun purchasing them on the secondary market, they are likely to become increasingly available from lenders.
Cons
The longer the term, the more you pay towards interest. Not only are the interest rates on these loans slightly higher, but you'll end up paying nearly
twice as much interest over the term compared to what you would pay with a standard 30year fixedrate loan. In addition, these loans are not yet
readily available as 30year mortgages.
InterestOnly Mortgage
This is not a type of mortgage, but an option you can add to any mortgage product (if available). With conventional loans, your monthly mortgage payment is allocated to both principal and interest. If you add this option  let's say, for the first five years  you pay only interest during this fiveyear period. In the sixth year of your loan, you begin paying both interest and the principal. Adding this option can be problematic, however, as it will likely increase your monthly payment significantly once you begin paying both interest and principal. For example, say you have a 30year, fixedrate mortgage for $100,000. You add an interestonly option for the first five years. At the end of the five years, you start paying back interest and the principal. Because you have only paid interest over the last five years, you end up paying the entire $100,000 principal plus interest in 25 instead of 30 years. Basically, you end up paying a $100,000 mortgage over a 25year term. Had you paid interest and principal in the beginning, the payment would be $537. With a 25year term, the payments are $585.
Jumbo Loans
Pros
Jumbo loans are used when the loan amount exceeds guidelines set by Fannie Mae and Freddie Mac. As discussed earlier, Fannie Mae and Freddie Mac are
federal governmentsponsored investors that purchase loans on the secondary mortgage market. Lenders selling residential mortgage loans to these
entities must follow their underwriting guidelines in order to participate.
In 2005, the limit for a onefamily, residential loan was set at $359,650 in the continental U.S., and $539,475 in Alaska, Hawaii, Guam and the U.S.
Virgin Islands. Any single loan that exceeds Fannie Mae's limits is considered a jumbo loan, and will carry a higher interest rate than a conventional
fixedrate mortgage. This is a good loan if you need more money to secure the space you want and can afford it.
Cons
Interest rates are often higher on these large loans. Thus, the loan may have a higher monthly payment, and will cost more over the long run due to the
interest rate. Because jumbo loans are typically considered higherrisk, the criteria for securing these loans is typically very strict, and you will
need to have a higher income level to qualify.
Government Loans
Unlike many homebuyer programs, Federal Housing Administration and other governmentbacked loans and mortgages are not limited to firsttime homeowners. Select guidelines for standard government loans include:
 Terms of 15 or 30 years, with either a fixed or ARM loan
 Gift funds from nonprofit organizations, family members or friends can be used for the down payment
 No payment reserves are required for mortgage insurance
 Maximum total debt ratio is 41% (Visit Chapter 8 for more information on property debt ratio)
 Loans are assumable, meaning another party can take over the loan as long as they meet all of the FHA's requirements and qualifications
 Loan amounts are capped
Cons
These loans have both income caps and limits on the mortgage amounts. Government loans also include additional criteria that borrowers must meet to
obtain the loan.
Piggyback Mortgages
Pros
Also known as 801010 loans, Piggyback Mortgages eliminate the need for Private Mortgage Insurance (PMI) by allowing borrowers to access equity in the
space as the down payment. Basically, a second mortgage is "piggybacked" onto the original mortgage loan. This "piggybacked" loan helps to cover part
of the down payment, and has a term length as long as the original mortgage. When compared to PMI, a piggyback mortgage might be a cheaper alternative.
For example, if the first loan covers 80% of the home, a piggyback loan would cover an additional 10% of the mortgage; this reduces the down payment to
10%. Equity in the property accumulates faster, because extra payments are made towards the principal, and you can obtain a larger mortgage loan while
avoiding a jumbo loan's higher interest rate or monthly PMI payments.
Cons
Not everyone will qualify for a piggyback loan, and the savings aren't guaranteed. Also, you will have to make two separate mortgage payments each
month. Tax laws might limit the amount of mortgage interest you can deduct from your taxes. Finally, the interest rate for the second loan might be
higher.
VA Loans
Pros
The Department of Veteran Affairs guarantees fixedrate VA loans for qualified U.S. military veterans. Offered in terms of 15 or 30 years, VA loans
usually do not require a down payment, and have less stringent criteria than conventional loans. These loans will also accept funds from gift programs,
other loans or grants from certain sources to be used for the down payment (if required) and closing costs. As of December 2004, the maximum loan
amount was raised to $359,650. In addition to debt ratios, VA loans use a residual income calculation to assess applications. Say, for example, that
a lender allows a debt to income ratio of 30%, and requires a residual (leftover) income of $1,000 per month. Although 30% of the borrower's income
goes towards debt each month, after debts are paid, the borrower must have $1,000 remaining to allocate towards property expenses. So, if the borrower
had a monthly income of $1,200, and debts of $360/month, s/he could not qualify for the loan. Although the borrower meets the debt ratio requirements
($360 is 30% of $1,200), s/he does not meet the residual income requirement ($1,200$360 = $840). In this example, the borrower would need to earn at
least $1,360 per month to meet both the debt ratio and residual income requirements ($1,360  $360 = $1000).
Private Mortgage Insurance is not required for VA loans, but is instead replaced by a VA funding fee that varies from 1.25% to 3.3% of the property
value. The fee helps to fund program operations by paying claims to lenders who would otherwise lose money by making loans to subprime
(underqualified) borrowers who default on their loans. This fee also goes toward paying lenders who normally would not make these loans were if not
for the VA funding fee.
Cons
You must be a qualified U.S. veteran to qualify, and can only use the loan for residential property. You must also occupy or intend to occupy the
property as a home for yourself within a reasonable period of time after closing the loan  i.e., the loan cannot be used to purchase rentalonly
property.
AdjustableRate Mortgages
Now that you know more about the range of options available fixedrate mortgage options, it is time to explore the ins and outs of adjustablerate
mortgages (ARM). The primary difference between fixedrate and adjustablerate mortgages is that interest rates for ARM loans fluctuate over the loan's
lifespan, which changes your monthly payments throughout the loan term.
As with fixed loans, there are many ARM products to choose from. Different ARM loans share common characteristics:

Initial or Introductory Rates:
The initial interest rate of an ARM loan.
Starting rates are generally 14% below those on conventional 30year, fixedrate residential mortgages. Although these low rates may allow you to qualify for a higher mortgage, remember that the interest rate may increase in the future. Borrow a reasonable amount so that you can handle the payments if the interest rate increases. 
Adjustment Intervals:
How often the loan's interest rate changes throughout the term.
Adjustment periods vary depending on which ARM product you choose, and occur throughout the loan's lifespan at regularly scheduled intervals. At the end of an adjustment period, the interest rate change takes effect. The first interest rate change will not occur until a set number of years have passed. For example, with a 3/1 ARM, the first rate change occurs after three years have passed, and will change every year thereafter for the remainder of the loan term. On a 7/1 ARM, the first rate adjustment occurs after seven years, and then on a yearly basis. Other adjustment period choices include yearly and 5/1. The mortgage contract will describe the adjustment period.  Index: Lenders use the index to determine the new interest rate on your loan for the next adjustment period. The index is a financial market indicator used by lenders to calculate the costs they incur to lend you money. Because index rates continuously rise and fall, your mortgage contract will note the date the index is calculated. The index calculation typically occurs one to two months prior to the anniversary of the loan. How does this affect your loan's interest rate? If the market indicates through the index that it is risky for lenders to loan money to you, you can expect a higher interest rate, or vice versa.
 Adjustment Margin: This is a set percentage amount  the margin  that the lender adds to the index rate. Lenders use this margin to help determine your ARM's interest rate during the adjustment period. The margin amount remains constant over the life of the loan, and is between 13 %. The adjustment margin should be outlined in the mortgage contract. When it is time for your loan adjustment, you can "estimate" your new interest rate by adding your loan's margin to the index rate. For example, if you have a margin of 2% and the index is set at 5.5%, you can estimate that your new interest rate will be around 7.5%.
Confused about how interest rates in ARM loans work? Don't be. Just remember:
 The Index and Adjustment Margin are used to determine your interest rate.
 Each year, the Adjustment Interval indicates when your "new" interest rate will begin.
And what about the Introductory Rate? Well, it's so low that you will probably not see this rate while you repay your mortgage.
Additional Factors
Let's take a look at other aspects of the ARM loan you need to note when comparing mortgage products:
Interest Caps
These limit how much your interest rate can fluctuate, and protect you from unexpected changes in the rate at adjustment periods and over the loan's
lifespan. Caps vary among lenders, but are typically set at 2% and 6%.
There are two types of interest rate caps: lifetime and periodic.
 Lifetime Caps: These limit how much the interest rate can increase over the life of the loan. For example, if your loan had a "5% lifetime cap," your rate can not increase more than five percentage rate points over the initial rate no matter how high the index rate climbs. So, if you started with a 5.5% initial rate, the highest interest rate you could be charged on your loan would be 10.5%. By law, your mortgage contract must include a lifetime cap.
 Periodic Caps: These limit the interest rate increase from one adjustment period to the next. This cap shields the borrower from steep payment hikes from one adjustment period to the next. For example, your mortgage contract could provide that, should the index rate increase four points in one year, your rate could only rise two points.
Payment Caps
This cap limits your monthly mortgage payment throughout the loan term, and requires that  after an adjustment period  your new monthly payment can
only increase by a certain percentage of the previous payment. Your mortgage contract will detail the increase.
For example, the payment cap might indicate that your adjustment cannot increase more than 20% from your previous payment. If your old monthly payments
were $500 per month, then the payment cap would limit the increase in your adjustment to 20% (or less) of $500. This would result in a maximum increase
of $100, or a new payment of $600 ($500 x 1.20). The next adjustment could again increase another 20%, but would be based on the previous payment of
$600.
Payment caps can result in negative amortization during months when high interest rates require you to pay more than the payment cap allows. During
months of negative amortization, the outstanding balance of the loan actually increases. During these months, your payments  due to the cap  are
insufficient to cover the cost of the loan created by a rising interest rate. This results in a monthly payment deficit.
Using our previous example, the payment cap limits the loan increase to 20%. However, a 25% increase would be necessary to cover the costs due to
rising interest rates. So, if your payment amount is capped at $600, but you need to pay $625 to cover the interest, each month you would have a $25
payment deficit. In one year's time, you would accumulate an additional $300 towards your loan debt.
At some point during the loan (usually towards the end), you will be required to make monthly payments large enough to pay off the principal and any
accumulated interest you owe. When this day arrives, you might face repaying a large portion of the loan principal and accumulated interest in a
shorter amount of time. This could translate into extremely large payments until the loan is completely paid off.
Other questions to ask if you are considering an ARM loan include:
 Conversion: Can you convert the ARM to a fixedrate mortgage? A convertible ARM might enable you to lock in a lower fixedrate at a later time.
 Prepayment Penalties: Will you have to pay a fee or penalty if you refinance or pay off the ARM early?
 Any other concerns you have.
Pros and Cons
 ARM loans are great, especially if you have limited money to get into the marketplace. Their interest rates are typically lower than conventional fixedrate residential loans, which allows you to borrow more. This can translate into more purchasing options.
 The downside is that, because the interest rate fluctuates throughout the term, skyrocketing interest rates will lead to skyrocketing monthly payments. Ensure that you can handle the maximum payment requirements if your interest rate rises, and learn how margins, caps and adjustment intervals will affect your monthly payment (as well as how and when each is calculated).
Interest Rates
 After deciding which type of loan is right for you, figure out what an affordable monthly mortgage payment will be. Your payments reflect both the interest and principal of your loan, which in turn affects the loan amount you can obtain. If you have a high interest rate, you might consider taking out a smaller loan. Smaller loans translate into fewer purchasing options, but also mean smaller monthly payments.
 How does interest affect your monthly payments? View one of the following charts to see how your mortgage payment is affected by interest rates. To view the 15year and 30year fixedrate tables, download the attachments.
 To use the tables, find the interest rate for your mortgage at the top, then skim down that column until you find a payment (includes interest and principal) that you can manage. Moving left across the row will give you the loan amount for which you need to qualify.
 Payments do not include private mortgage insurance, property taxes or homeowner's (hazard) insurance. Including these expenses in your monthly mortgage payment will increase your monthly payments by hundreds of dollars each month.
 TIP: To get an idea of how a mortgage will amortize, access The Mortgage Rate Directory
 TIP: Fannie Mae changes it loans limits each year. Find out current loan limits