Unless you're a first time home buyer with a hefty wad of cash, you're going to have to deal with the financing question before you can purchase your home. And with so many different types of mortgage loans available, it takes a little knowledge and investigation to determine which type is right for you. Below is a list of some of the most common types of mortgages and how they operate. Since the descriptions don't contain every minute detail, be sure to check with a qualified mortgage broker before making a decision as to which is the best type of mortgage for you.
Conventional Mortgage
The conventional mortgage is exactly what its name implies; it is the type of mortgage most often used in times past before all these other options became available. The conventional mortgage is generally a 30-year product with either a fixed rate or an adjustable rate.
Conventional mortgages are extremely hard to get for first-time home buyers, especially in the current financial climate the country finds itself in. Conventional mortgages require buyers to provide a substantial down payment, have an excellent credit rating, and purchase a home with a favorable loan-to-value ratio for the lending institution. Conventional mortgages are so difficult to get that first-time home buyers almost never qualify.
FHA Mortgage
An FHA mortgage is similar to a conventional mortgage except for one major feature: it is secured by a promise from the Federal Housing Administration and HUD. The FHA mortgage is a loan made by a bank or other lending institution with the understanding that if the borrower defaults, HUD will step in, pay the balance on the mortgage, and then sell the home to a new home buyer. This is a good deal for banks because it allows them to make more loans with less risk.
FHA loans are advantageous to first-time home buyers because the requirements are a lot less stringent. With FHA loans, first time buyers can get away with smaller down payments, gifts from relatives, and other creative means of paying the costs of buying a home. Generally these mortgages have a fixed rate for 30 years; sometimes you can find them with adjustable rates. The disadvantages of the FHA mortgage include the lack of assumability and certain restrictions which prohibit some types of gift programs.
Interest Only Mortgage
An interest only mortgage is one in which the homeowner makes monthly payments that cover only the interest on the mortgage, and any amounts due in his escrow for taxes and insurance. In other words, for a specific amount of time (usually 5-10 years) the homeowner is not making any payment towards the principle of the loan.
The trap with this type of loan lies in the fact that homeowners can get comfortable with their current mortgage payments, extending themselves right to their budgetary limits, and then find they can no longer afford the home once principal payments kick in. Sometimes these interest only mortgages also have a "balloon" feature which requires the entire balance of the loan be paid somewhere around the 20-year mark.
The only advantage to an interest only mortgage is that it affords lower monthly mortgage payments for the first 5 to 10 years of the loan. This may be advantageous to people who are looking to buy more house than they can really afford, in the hopes that their financial position will improve before principal payments kick in. The obvious disadvantage is the fact that once principal payments do kick in, the monthly mortgage payment will be substantially higher. Holders of interest only mortgages also end up paying considerably more interest because they are not paying down the principle for the first years of their loan.
Balloon Mortgage
A balloon mortgage is similar to a conventional loan except for the fact that at the end of the term the entire balance is due. For example, you may have a balloon mortgage with a time frame of 10 to 12 years, in which you will make standard monthly payments similar to anyone else's mortgage. But when the balloon date arrives you are then required to pay off the entire balance, regardless of what it is.
The main advantage of this type of loan is the fact that you will pay significantly less interest overall because the loan is paid off earlier than a conventional loan. The obvious disadvantage is the fact that you will need a substantial amount of cash in order to pay your debt on the balloon date. If you cannot pay the debt, you will either have to look at home refinance or risk foreclosure.
Bi-weekly Mortgage
A bi-weekly mortgage is similar to a conventional or FHA mortgage in that it is typically 30 years and can be either fixed-rate or adjustable-rate. The idea behind the bi-weekly mortgage is to make payments every two weeks rather than just once a month. Doing this means that you will actually end up paying the equivalent of 13 months worth of loan payments rather than just 12. While this may not seem significant, that thirteenth payment is applied directly to your principal, which then reduces your interest accordingly. Using a bi-weekly mortgage helps you pay down your loan faster and save you significant amounts of interest.