Types of Mortgages
Most homes are bought with a mortgage, although some buyers pay all cash, which is less common and does not qualify for the tax benefit of deducting interest paid on the loan since there is no loan. A mortgage is a loan to purchase a property and must be paid back to the lender over a certain period of time. The mortgage interest rate is the cost that the lender is charging for lending the buyer money to purchase a home. While there are many kinds of mortgages such as interest only (rare nowadays), seller financing, below are the most common mortgages today:
- 30 Year Fixed (principal & interest)
Mortgage is paid off over a period of 30 years with the interest rate staying the same for all 30 years. Total interest paid to the lender will be greater than a 15-year mortgage since you will be making payments for an extra 15 years. A 30-year mortgage would have a lower monthly payment though, since less principal is being paid off each month. It is easier to qualify for a 30-year fixed mortgage because a 15-year mortgage would make your monthly debt higher.
It is possible to pay off a 30-year mortgage early by applying double the principal on each payment (not double the entire monthly payment). You should always make sure lender does not charge pre-payment penalties prior to obtaining a mortgage with the specific lender. Below is an example of how to pay off a $100,000, 30-year fixed mortgage early by paying extra principal:
Month Principal Interest Interest Rate Total Loan Balance 1 $81.97 $583.33 7.00% $665.30 $99,918.03 2 $82.45 $582.85 7.00% $665.30 $99,835.58 3 $82.93 $582.37 7.00% $665.30 $99,752.65 4 $83.41 $581.89 7.00% $665.30 $99,669.24 - - - - - - - - - - - - 359 $657.61 $7.69 7.00% $665.30 $661.31 360 $661.31 $3.99 7.00% $665.30 - Check the amortization schedule or obtain it from the lender if you do not have it. For the 1st month, by paying the 2nd month's principal for a total of $747.75 ($665.30 + $82.45), month 2 has been eliminated saving you $582.85 of interest payment. The next payment's principal (month 3) will be $82.93, so by paying the following month's principal (month 4) of $83.41, you have just paid off 4 months of mortgage in 2 months with only an additional $165.86. Lenders make most of their profits during the early years of a mortgage with the high interest amounts, so it is essential to pay extra principal at the beginning while the principal is still low. A homeowner should not pay extra principal if there are any credit card debts which do not have a low interest rate (i.e. below 5% annually) Extra payment should go towards paying off the credit card with a high interest rate.
- 15 Year Fixed (principal & interest)
Mortgage is paid off over a period of 15 years with the interest rate staying the same for all 15 years. Less interest in total will be paid to the lender after 15 years, however total monthly payments will be higher since more principal is being paid off each month. Many people like the idea of having their mortgage paid off in 15 years rather than 30 years, but in most cases, a 30 year mortgage can be paid off in 15 years as well provided that the borrower doubles the principal amount each month and the lender does not have any pre-payment penalties. - 40 Year Fixed (principal & interest)
Mortgage is paid off over a period of 40 years with the interest rate staying the same for all 40 years. Total interest paid to the lender will be greater than a 15 or 30 year fixed mortgage since payments will be made for a longer period of time. 40-year fixed rate mortgages usually have a higher interest rate and generally selected only when the home buyer cannot qualify for a 30-year fixed rate loan. - Adjustable Rate Mortgages (ARMs)
Interest rate is adjustable as stated in the contract (i.e. monthly, every 6 months, or every 12 months) based on the interest rate of the market. This type of mortgage is not advised as the lower interest rate versus a 30 year fixed is usually not that significant and the buyer bears the risk of having a much higher monthly payment if the interest rate adjusts higher. Higher interest rates can typically cost hundreds of dollars more each month and sometimes more than $1,000, depending on the loan size. Some people would argue that they plan to sell the house after 2 or 3 years so it would be wiser getting an ARM to obtain a lower interest rate. A buyer should always ask themselves one question - can the sale of the home after 1, 2 or even 5 years without a loss be guaranteed? If not (which is generally the case), and the mortgage payments go up $500 or $1,000 a month if the mortgage interest rate adjusts higher, will the buyer be perfectly fine? Chances are no. It is usually better to play it safe and stay away from ARMs. - Hybrid Mortgage
A mix between a fixed rate mortgage and an adjustable rate mortgage. Interest rates are fixed for a period of time; say 10 years, then changes to an ARM which can have a significantly higher interest rate and higher payments if rates are adjusted higher. This type of mortgage is safer than an ARM but not as safe as a 30-year fixed mortgage.
