Kill the Confusion: The Real Lowdown on Loans, Mortgages & Down Payments

published Dec 12, 2016
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Thinking about buying a home? If you’re not familiar with how mortgages and down payments work—and how many different types there are—you could be missing out on choosing one that works perfectly for you. Here is a breakdown of 11 different types of mortgages, from the most common to the mostly rare, and a rundown on how down payments work.

But First, Some Facts…

What’s a down payment, and how do they work?

A down payment on a home is the initial sum you pay towards the home you’re buying, that’s calculated as a percentage of the total cost of the property. The down payment goes to the seller of the home, and when you take out a mortgage, the lender pays the rest of the cost of the property—which you pay back to the lender over many years, with interest. The reason you’re required to pay a down payment for most traditional mortgages and loans? If you fail to pay your mortgage and your home is foreclosed on, you lose your down payment—essentially, it’s incentive to make sure you make the monthly payments.

What’s the recommended down payment amount?

You’ll typically hear that a solid down payment is 20 percent of the purchase price—that’s the most commonly recommended amount, which means you’d end up paying the other 80 percent of the loan through the mortgage, plus interest. Not all loans require a 20-percent down payment, though. But paying lower than 20 percent generally requires you to pay mortgage insurance (adding to your monthly payment), or pay more in other roundabout ways. The absolute minimum down payment you can make is usually 3 percent.

What is mortgage insurance, and will you need it?

Mortgage insurance is an additional cost that borrowers pay along with their monthly payments (or during closing), which lowers the risk to the lender and allows borrowers to qualify for loans even if they typically wouldn’t. You will likely need mortgage insurance if you pay less than 20 percent down, but it also depends on the type of loan you take out.

Main Loan Types:

While there are many different types of mortgages for many different people with different needs, the two main types of mortgages are fixed-rate and adjustable-rate loans—most other loans will be one or the other, even with their other criteria and restrictions.

Fixed-Rate Loan

How it works: Fixed-rate mortgages (FRMs) get their name because their interest rate doesn’t change for the life of the loan (so your monthly payments are always the same). They’re the most common type of mortgage because they’re predictable, but they do have some disadvantages—namely, if you agree to your mortgage while interest rates are up, but they drop after you lock in your rate, you’re stuck paying the higher interest. You can get a 15-year or a 30-year FRM—30 being the most common.

Adjustable-Rate Mortgage

How it works: Unlike FRMs—and as the name suggests—adjustable-rate mortgages (ARMs) come with a low introductory interest rate (that’s temporarily fixed for 2 to 5 years) and don’t lock you in to a set interest rate for the life of the loan. Once your introductory interest rate period is up, your interest will either go up or down depending on what the average interest rates are at the time. ARMs work best for people who can’t afford higher interest rates going in, or who aren’t sure how long they plan to stay in their home. Some ARMs also come with a prepayment penalty, meaning you can’t pay it off early for a certain amount of time—and refinancing or selling during that period will cost you.

Other Alternative Housing Loans:

If you qualify for one of the alternative loans below, it can make your homeowner dreams even more of a reality.

Federal Housing Administration Loan

How it works: Federal Housing Administration (FHA) loans are government-insured mortgage loans that work best for people looking to buy a home without a huge savings, or for those who don’t have perfect credit. The loans are usually fixed, aren’t very flexible, and most are limited to around $400,000. The perks? FHA loans come with far lower down payments (typically 3.5 percent) than traditional loans, but because the FHA isn’t actually the lender—just the backer, or insurer—you’ll have to pay mortgage insurance on top of your monthly payments and interest.

Veterans Affairs Loan

How it works: Veterans Affairs (VA) loans are special government-backed loans designed to help veterans buy homes. In order to qualify, you have to have a Certificate of Eligibility (to prove that you served a specific amount of time—usually 90 or 181 days) and suitable credit and income. VA loans generally allow you to forego a down payment altogether.

USDA Rural Development Loan

How it works: USDA mortgage loans are another government-backed type of loan that help people with low and moderate income buy homes. Those with low or very low income (between 50 and 80 percent of, or 50 percent below the median income of the area) are eligible for direct loans, while those with moderate income (up to 115 percent of the area median income) are eligible for guaranteed loans. With these loans, your closing costs may be covered and you may also not even have to pay a down payment.

Energy Efficient Mortgage

How it works: If you’re looking to purchase an energy efficient home, or remodel a home to be energy efficient, you may be able to get an energy efficient mortgage which provides you with financial incentives for going green. Your home would have to be inspected by energy experts in order to qualify, but if you do, there are some perks—your home value would be increased if you were to sell it, and you may even get tax deductions out of it. You can also potentially qualify for larger loans.

Interest Only Mortgage

How it works: With interest only loans, home buyers will only make payments towards the interest (not the principal balance) for a set term, which is usually 5 to 7 years. After the term is up, borrowers can make a lump sum payment, start paying towards the principal balance, or refinance their home. This type of loan works well if you plan to sell your home after a few years (after the term is up.) One of the pros of this type of mortgage—during the interest only term, all of your payments are tax-deductible.

Growing Equity Mortgage

How it works: Growing equity mortgages work for borrowers who can’t afford or qualify for a traditional home loan. With a growing equity mortgage, your monthly payments start out small, and gradually increase over time. Growing equity mortgages are fully-amortizing, which means your monthly payments cover all the interest for the month and a part of the principal balance. With this type of loan, you ultimately pay less interest and can shorten the term of your fixed-rate mortgage.

Graduated Payment Mortgage

How it works: Graduated payment loans are similar to growing equity mortgages in that your monthly payments go up gradually every month, but they’re different in that they’re not amortizing—so you don’t pay all of the interest, and whatever is left over gets added to your principal balance.

Balloon Payment Mortgage

How it works: Balloon payment mortgages are less common, and you’ll understand why as soon as you hear how they work—it’s similar to an interest only mortgage, in that your monthly payments go to paying interest (although sometimes a small amount will go to the principal balance) until the loan matures. Once the loan matures, you have to pay off the rest of the balance. This means the initial payments are low and manageable, but you’ll be hit with a big sum at the end to pay off, so you’ll have to focus on saving up for the payment at the end while you make the monthly payments.

Bridge Loan

How it works: If you already have a mortgage on a home but want to buy another one before you sell it (say, if you’re living in one home, want to move into another one and then sell the first one) a bridge loan can help you finance it. They’re called bridge loans because they “bridge the gap” between your old mortgage and your new one. Bridge loans are short term and temporary, not to mention rare and difficult to qualify for. Borrowers with bridge loans would have to pay it off, then get a new mortgage for the new home and could end up paying extra in closing costs.

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