Understanding the Different Types of Mortgages & Which One is Best For You
When purchasing a home, one of the first decisions you must make is which type of mortgage best meets your requirements. This decision will depend on several factors such as your budget and debt-to-income ratio.
When looking for a mortgage, there are various options to consider, such as fixed-rate and adjustable-rate loans, as well as jumbo mortgages and interest-only options.
Fixed Rate Mortgages
Fixed rate mortgages are the most popular type of home loan. They’re ideal for borrowers who need predictable monthly payments and stability in their interest rates, as well as those planning to stay put for an extended period of time without plans of selling anytime soon.
Fixed rate mortgages offer the stability of having the same payment throughout the term of your loan, unless you decide to refinance. You have the option of choosing a 30-year fixed-rate mortgage; however, shorter terms such as 15 and 20 year mortgages also exist and offer additional advantages for borrowers.
These loans tend to be more costly than adjustable-rate mortgages (ARMs), but they can be an advantageous choice if you plan to stay in your home longterm and have a steady income. Furthermore, they offer a fixed interest rate which helps protect against large changes in income that could cause significant increases in monthly payments.
Arms typically start with lower interest rates than fixed-rate mortgages, but they are subject to adjustment. Some ARMs even allow a cap on how much the interest rate can rise during any given interval, giving you some control over your monthly payments if the market becomes more expensive.
The drawback to ARMs is that they often adjust more frequently than fixed rate mortgages and the rates can change drastically. If you’re uncertain whether an ARM is suitable for you, speak to your lender about your financial objectives and how they align with current mortgage market conditions.
Another disadvantage of ARMs is they can be more difficult to qualify for than fixed rate mortgages. A higher credit score and debt-to-income ratio are typically required, so make sure you comprehend these conditions prior to applying for one.
Fixed-rate mortgages make budgeting much simpler, since your monthly payments remain consistent throughout the loan term. This is especially beneficial if other expenses such as rent, insurance and taxes may change during the course of your mortgage.
Adjustable Rate Mortgages
When looking for a home loan, adjustable rate mortgages (ARMs) may come into play. These loans can be obtained from many of the same lenders as fixed-rate options and offer borrowers more freedom than their fixed-rate counterparts; however, they could become costly options should interest rates increase.
Many ARMs begin with an initial introductory period, during which the loan’s interest rate may be lower than with a fixed-rate mortgage. This could last anywhere from months to years or even several decades. Once that period ends, however, your rate will gradually change at regular intervals.
The duration of an introductory period is critical in determining how long your loan’s interest rate will remain low. Popular choices are three, five and seven years.
ARMs typically feature rate caps that restrict how much the interest rate can increase during the introductory period and on subsequent anniversaries. These limits are usually calculated based on an index calculated approximately 45 days before each anniversary.
Another type of ARM that borrowers might consider is a payment-option ARM, which offers several different monthly payment options to choose from. These can include paying only interest, making minimum payments that do not cover all the interest due, or fully amortizing payments which include both principal and interest components.
These ARMs can be risky because borrowers might enjoy low payments during an introductory period but end up owing more than the original loan balance once that period ends and interest rates adjust. Though these ARMs became scarce after the Great Recession, some lenders still offer them.
Selecting an ARM is a major financial decision, and you should carefully assess your finances before making this choice. Don’t make a choice that puts an unnecessary strain on your budget or causes you to worry about making monthly payments.
Jumbo Mortgages
Jumbo mortgages are loans that allow homebuyers to finance homes worth more than the federally imposed conforming loan limit. This limit is determined by the Federal Housing Finance Agency (FHFA) and adjusted annually to reflect changes in living costs.
These limits are designed to make it simpler for those who can’t afford to purchase their homes outright with cash. Furthermore, they permit borrowers to avoid having to divide the full loan amount into multiple smaller mortgages.
Many homeowners seeking to purchase a large or luxury property in an expensive area will discover that the conforming loan limit doesn’t meet their needs, necessitating them to obtain a jumbo mortgage for financing their purchase.
Jumbo mortgages require more stringent credit qualifications than their traditional conforming loan counterparts, such as having a higher credit score, low debt-to-income ratio and either an impressive down payment or substantial cash reserves.
Jumbo mortgage qualification requirements differ by lender. Most require a FICO score of at least 700 and may also want to see your debt-to-income ratio below 45%. Furthermore, lenders check to see that you have sufficient cash reserves for six months’ worth of mortgage payments, according to Cohan.
Jumbo mortgages usually carry higher interest rates than conforming mortgages, though this depends on market conditions. Nonetheless, they remain more budget friendly than 30-year fixed-rate loans.
As with any mortgage type, jumbo loans come with some intricate details that may be challenging for consumers to comprehend. One major drawback is that not everyone qualifies for them so you’ll need to shop around in order to find the best rate and terms available.
If you’re uncertain if a jumbo mortgage is suitable for you, contact a BMO Mortgage Banker to learn more about your available options. They will assist in determining if a jumbo loan is the most advantageous solution in your situation and offer you a personalized quote so that you can compare rates and terms between various jumbo mortgages.
Interest Only Mortgages
An interest-only mortgage (IO mortgage) is a home loan that only requires you to pay interest on the money borrowed for a set period of time. At that point, you have several options; refinancing, making a lump sum payment or beginning principal repayment; however, be aware that your payments will be much higher than during interest-only mode.
These loans are ideal for homeowners who plan to own their homes for only a short time, such as five or 10 years. Furthermore, they can benefit those looking to save money by paying down the loan’s principal rather than its interest.
Potential Tax Advantages: Interest payments of up to $1 million annually may be deducted from federal income taxes, depending on your tax bracket. However, you could potentially forfeit any potential savings if market values decline during the loan’s interest-only phase and you cannot recoup the full value of your initial down payment.
Strict Lending Requirements: Lenders are required by law to verify your ability to repay the full loan amount at the end of an interest-only term, so they will conduct a detailed financial assessment and inquire about any assets, investments or retirement savings that can be converted into cash.
Increased Risk: Interest-only mortgages pose more of a risk for lenders than conventional loans, since you won’t reduce the balance of your home loan until several years down the line. Furthermore, lenders typically require higher credit scores and down payments than with conventional loans in order to approve an interest-only loan.
If you’re thinking of taking out an interest-only mortgage, consult a knowledgeable lender who can guide you through the various options and help weigh the benefits and drawbacks of each. It is best to shop around for the best rate tailored towards your individual needs and financial objectives.
