A Mortgage Primer: Understanding Loan Types, Benefits, and Pitfalls

Fixed, variable, jumbo, reverse, subprime–there seems to be a mortgage for every color of the rainbow. But what’s the difference between these mortgages, and which one is best for you?

Everyone's got their own style, and the mortgage market has created loans of all sizes and shapes. (If you're wondering whether I took this photo with this very post in mind, the answer is yes.)

The mortgage market has gotten complicated with the advent of new loans and fancy financing options. Over the past decade, with the housing bubble growing and growing, inventive bankers created evermore ways to help homebuyers purchase a home. Even today, the options are enough to make a homebuyer’s head spin. Here we’ll cover the basics of the most popular mortgage loan types. (As always, carefully review your finances with a professional–preferably someone not making a commission off your loan–before entering into a mortgage.) Let’s dive in!

Common mortgage types:

Fixed Rate Mortgage (FRM). This is the “classic” mortgage (at least, in the US), where a lender offers you an interest rate that won’t change over the term of your loan, which can be 5-years, 10-years, 15-years, 30-years, or even longer. The most common lengths are usually 15- or 30-years. The attractive feature of these loans is that they’re totally predictable. You’ll pay the same amount each month for the duration of the loan. Your property tax rate may get wonky, which could impact your monthly payment, but your mortgage won’t change.

Adjustable Rate Mortgage (ARM). This is a loan where the lender has you pay a certain interest rate or a schedule of rates for a period of usually 1 – 7 years. Then the interest rate adjusts, usually according to some index that the lender designates (for example, one index used could be the 1-year Treasury Index).

A common example is a 5/1 ARM (technically a “hybrid”, since it has both fixed and adjustable periods). You repay the loan at a certain low interest rate for 5 years, then the rate adjusts every year (that’s what the “1″ refers to) to move with the Treasury Index, say.

These loans are attractive because the monthly payment for the first 5 years is very low. The reason you’re able to get this low rate is because you’re agreeing to take on the lender’s risk. In other words, when a lender offers a fixed rate, they suffer when interest rates go up, while you coast along with your fixed rate. In the case of an ARM, you ride the wave up and down with your lender, and in exchange, your interest rate is lower. But after the 5 years (or whatever the initial period is) ends, your interest rate will adjust and could be higher than the initial rate. There are all sorts of different provisions and rates built into a loan like this which determine the “rules” around rate resets. You’ll need to look in your loan docs for things like index, margin, caps, negative amortization, and convertibility. To dig a bit deeper on these loans, you can read more here.

Ads for Reverse Mortgages in lower-income areas with a concentration of older people (this one is in San Francisco's Mission District) make me nervous. Reverse Mortgages can be a great tool--but only in certain cases.

Reverse Mortgage. This type of mortgage is available only to seniors. In a reverse mortgage, a homeowner can tap into their equity to generate income for basically any purpose. The homeowner makes no payments; instead, the bank pays the homeowner monthly installments or a lump sum, and interest is added to the lien on the property (meaning the property can’t be sold until that interest is paid back and all liens removed). Even though the homeowner is receiving payments, it is still a loan and all this money, plus interest, must be paid back to the bank once the homeowner(s) die or move out permanently (into aged care, for example). This can be a good option for older people–in some cases. You don’t need good credit to get the loan, it can provide much needed cash to cover medical or living costs, and as long as the homeowner is alive, they can stay in their home. Some drawbacks include hefty up-front costs, and it can be a dangerous situation if the homeowner has a spending problem. Learn more here and here.

Interest Only Mortgage. For the first 10 years of your loan (usually), you pay only interest. No principal. After 10 years, your loan gets amortized and you start paying both principal and interest. People get these loans because they like the low monthly payments for the first 10 years. The thing is, over 10 years you’re building no equity (so you’re no closer to owning your home than you were a decade ago), plus you will likely pay a higher interest rate over the 10 year period because it’s a riskier loan for the lender.

Balloon Mortgage. During an introductory period of usually 5-7 years, you pay a low monthly payment. But at the end of the 5-7 year period, you will owe the balance of the mortgage in one huge “balloon” payment. You can choose to refinance rather than make the payment, but you’ll be subject to the whims of the market. If interest rates are high, your monthly payment will go up. If your home has gone down in value, it’ll be tough to refinance for the full loan amount.

Variations on the above mortgages:

Government Loan. Despite the name, this type of loan does not technically come from the government. With government loans, the government steps into the relationship between you and a lender to help guarantee the loan (all other loans are “conventional loans”). In other words, the government vouches for you, which is a big help to lower and middle income buyers, or those who can’t make large down payments and might not quality for a conventional loan. Government loan programs you may have heard of include the Federal Housing Administration (FHA), the Veteran’s Administration (VA) for veterans, and the Rural Housing Service (RHS) or Farmers Home Administration (FmHA).

Subprime Loan. These are loans extended to borrowers who fall into a risky (subprime, rather than prime) category, whether due to the size of the loan, the borrower’s credit score, or the type of loan. Subprime lending became a household dirty word during the 2007 Subprime Mortgage Crisis, but subprime lending has been around for ages, and when used responsibly serves a valuable function of extending credit to people who otherwise have a difficult time getting credit. Subprime lending is not synonymous with predatory lending, which is really what brought about the mortgage crisis.

Jumbo Loan. These are loans whose value is higher than conventional conforming loan limits, which are set by Fannie Mae and Freddie Mac. (Conforming loans are those which meet certain government guidelines – I know, the definition seems circular.) As of 2010, the limit is $417,000 for most US States and $625,500 for Alaska/Hawaii. You’ll generally have to pay higher interest rates if your loan falls into jumbo territory. A bigger loan means bigger risk for the lender, especially because luxury markets are fickle and properties don’t always sell quickly.

…phew! Did you make it through all that? The world o’ mortgages can be intimidating, but with a little education I’m confident that you’ll be armed with all you need to make a good decision for your home.

Is there anything that particularly confuses you about mortgages? What else do you want to know about mortgages? Have you witnessed (or been a victim of) predatory lending?