Which Type of Loan is Best? Fixed- Rate - Adjustable Rate - Bridge Loans - Convertible ARMs

All mortgage loans are not created equal. If you are looking for a loan, you have probably discovered the array of loan types and options. It can be confusing forthe first-time borrower, and even for those with more experience! Here, we will discuss the different types of loan options, and how they work.

First, there are two main broad categories of mortgage loans: government loans (FHA, VA, and RHS, or Rural Housing Service loans) and conventional loans (all other loans). In general, government loans have low or no down payment requirements for the purchaser, and are easier to qualify for than conventional loans. They are also guaranteed to the lender, which allows the borrower to obtain more favorable loan terms.

Conforming loan limits and terms on conventional loans are set each year by Fannie Mae and Freddie Mac; this determines who qualifies for an 'A' paper loan (they meet all requirements in their credit history, down payment, and other criteria), and who qualifies for other loan types. Just recently, Fannie Mae and Freddie Mac began offering 'B', 'C', and other loans which were formerly only offered by other lending institutions. These types of loans are offered to those with less than perfect credit.

There are several different categories of conventional loans. They include:

Fixed- Rate Mortgages

When refinancing a mortgage, the rates for fixed-rate mortgages will determine how high your payments are and how much you save if you decide to refinance. With fixed-rate mortgages, interest rates and monthly payment amounts remain static over the life of the loan, whether it is 15, 20, or 30 years (some lenders even offer 40 year loans). At the end of the loan period, you have paid off both the interest, and the principal for the loan. Normally, the shorter the loan period, the lower the interest rate that you pay; each month you are paying both the interest, and a little of the loan principal (this is known as 'amortization' and allows you to pay off the loan when the loan term ends). Most people choose either a 15, 20, or 30-year loan when getting a fixed-rate mortgage. Often, you can use a loan mortgage calculator to compare what your loan payments will be with different loan terms.

Be aware that the points (financing fees that lenders charge) and the APR (annual percentage rate) can also vary with different lenders; be sure to calculate those in when using the mortgage calculator to compare lending institutions. Normally, fixed-rate mortgages are a good option if you plan to live in your home for more than seven years.

Adjustable Rate Mortgages (ARMs)

Adjustable rate mortgages normally start off with low interest rates that can fluctuate during the term of the loan, based upon a loan index, such as treasury bill interest rates, the prime interest rate, or the Wall Street Prime Rate. Normally, the lender will add a margin to the index, which determines how much your monthly payments are.

The advantage of an ARM is low initial payments; but the disadvantage is the fact that loan rates can increase over time. If interest rates increase, your loan payments increase; although lenders will also put a cap on how often increases can occur (every 6 months, yearly, or every 3 years, for instance), and how much the loan can increase over the life of the loan (a lifetime cap). This makes ARMs an especially good option for the home buyer who only plans to live in their home for a few years, then sells before interest rates increase.

Some loans are a combination of fixed-rate and adjustable-rate mortgages. For instance, fixed-rate ARMs lock in a fixed interest rate for a certain period, such as 5 or 7 years, before allowing interest rates to rise. This gives the borrower a lower initial interest rate and lower payments during the early years of the loan than they would have with a conventional 30-year fixed-rate mortgage.

Two-Step Mortgage

This is a variation of the combination mortgage that offers low payment and interest rates in the early years of the loan, then 'steps up' the interest and payments to a higher rate at a pre-determined time, usually 5 to 7 years after the initial loan is made

Convertible ARMs

allow the borrower to convert the loan to a fixed-rate mortgage during the first five years of the loan, if interest rates are starting to rise. The conversion is done without a lot of finance fees, but the resulting fixed-rate mortgage will be at slightly higher than standard fixed-mortgage rates at the time it is locked in.

Balloon loans are short-term loans, in which you pay only the interest until the end of its term, when you pay the balance as a lump sum. They usually have terms that range from 3 to 7 years. The interest rate on balloon loans is usually quite low, with lower monthly payments; but paying off the lump sum can be difficult, which means that you may need to refinance at that time.

Some balloon loans provide a refinancing option that lets you change the balloon loan into a fixed-rate mortgage at the end of the term. Balloon loans are a good option for the person who intends to sell their home before the end of their loan term, since it keeps monthly payments quite low. The disadvantage is that you won't be building up equity in your home, since you are basically just paying interest on the loan.

Graduated Payment Mortgages (GPMs)

These mortgages start with low payments initially, then gradually increase the payments at set times. In essence, you are paying less than the interest rate early on, then paying this interest later on as the payments increase. GPMs are an option for the person who needs to qualify for a higher loan amount, and who plans to sell within a few years, or refinance before the payments become quite high.

Reduced down payment loans

Some lenders will offer the first-time homebuyer, or those with no equity in their previous home, a chance to obtain a mortgage with a low or reduced down payment. Down payments can range from zero to low amounts with these programs. It's important, when looking at these type of loans, to look at points, finance charges, and how the monthly payments will compare with other types of loans.

With these programs, lenders will finance the loan for a percentage below the going standard rates (such as 2% below) the first year, then the second and third years, for an amount slightly less than the standard interest rate (such as 1% less); after that, for the life of the loan, the normal interest rate applies. This allows a homebuyer to qualify for a larger loan, since the payments for the first few years are less, making it an option for the homebuyer who plans to sell after a few years.

A bridge loan is a special type of loan that allows you to temporarily finance your existing home until it sells, while at the same time you are purchasing a new one. You can use up to 80% of the equity in your current home as a down payment on your new home, and gives you a window of 3 to 6 months to sell your home in; at that time, payment is due in full for the loan.

These are a few of the major mortgage loan types available. Choosing the right one for you means becoming familiar with the terms and conditions of each one, and deciding which one best meets your specific needs.