Home Mortgage Types & Terminology
Buying a home usually means applying for a mortgage loan to cover the cost of the purchase. Besides negotiating a reasonable price for the house, you'll also need to shop around for a mortgage with an affordable interest rate and terms that ensure you'll be able to pay it back on schedule and keep your home.
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Fixed-Rate Mortgages
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A fixed-rate mortgage is one of the most common types of home loans. It is a long-term loan with an interest rate that doesn't change. Fixed-rate mortgages are named by their terms, which indicate how long the borrower has to pay back the loan. For example, a 5 percent, 30-year fixed-rate mortgage is one that charges an APR, or annual percentage rate, of 5 percent of the remaining principal, and the borrower must pay off the loan within 30 years. Because lenders measure mortgages in APR, you can divide the APR number by 12 to determine the monthly interest percentage.
ARMs
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ARMs are adjustable-rate mortgages and they are the second major category for home loans. An ARM has an interest rate that changes over time. A one-year ARM is a loan on which the lender can change the interest rate once a year. Unlike fixed-rate mortgage terminology, this does not mean that the borrower must pay off the loan within a year. One-year ARMs can still have 15-, 20-, or 30-year terms. Changes to the interest rate are based on an index, which is a compilation of economic factors that the lender uses to adjust rates. Your mortgage agreement, which is the document that you sign when you take out a home loan, lists the index and gives you the information you need to determine how much and how often your ARM rate can change.
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Hybrid Loans
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Some lenders offer hybrid home loans, which combine fixed- and adjustable-rate mortgages. These loans have names such as "3/17 year fixed." In this case, the mortgage has a fixed rate for three years before converting to an ARM automatically. A hybrid loan uses an index, just like an ARM. The adjustable portion of a hybrid loan may have caps; an annual cap represents the maximum yearly interest rate increase, while a payment cap limits your monthly payments but allows the interest rate to rise with no ceiling. This can create a situation where your monthly payment is less than the monthly interest charge. When your payment doesn't cover all of your interest, the remaining interest goes into the principal in a process known as negative amortization.
Second Mortgages
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Second mortgages are options for homeowners who already have a mortgage but also have equity in their homes. Equity is the portion of the home that the owner has already paid for. It changes as the mortgage borrower makes payments but also as the home's market value falls and rises. Second mortgages allow homeowners to borrow money, as either a lump-sum loan or a line of credit, using their home equity as collateral. Homeowners who take out a second mortgage must still repay the first mortgage according to its original terms but add new terms for the new loan.
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