In our overview of the mortgage market, we compare:
- Fixed rate or adjustable rate mortgages (ARM)
- Conventional or government-backed mortgages
- Conforming or non-conforming mortgages
- The pros and cons of balloon mortgages
When you are applying for a mortgage, it can be confusing to understand the main differences between the types on offer and decide which one is the most suitable for your circumstances. In this guide, we briefly weigh up your choices and which factors you should take into account before making that all-important decision.
Fixed rate or adjustable rate mortgage (ARM)
Fixed rate mortgages are the most popular mortgage type, making up an estimated 75% of the American mortgage market. The main difference between a fixed rate and adjustable rate mortgage is how the interest on your borrowing is calculated. With a fixed rate mortgage loan, your interest rate and your monthly payments remain the same throughout the entire loan period of 15 or 20 years although 30 years is the most common term. This is ideal if you want to know exactly how much your monthly mortgage repayments will be so as to budget more easily. Fixed rate mortgage holders aren’t affected by rises in the index rate which could make lending more costly. On the other hand, if interest rates go down, you won’t benefit from the drop.
ARM are called ‘hybrid’ financial products as they start with a fixed rate for an initial period (usually 5 years), and then the interest rate is reviewed and either increased or reduced to keep in line with the benchmark index rate which reflects market conditions. There are different types of ARM. For example, an 5/1 ARM means that the interest is fixed for 5 years and then is recalculated every year. The starting interest rate of an ARM mortgage is usually lower than a fixed rate loan. However, you don’t have the security of knowing how much your payments will be after the initial set figure making it more difficult to manage your money.
Conventional or government-backed mortgages
A conventional mortgage is based on, among other factors, your credit score and your debt-to-income ratio and is available from different lenders in the market. Various schemes such as the FHA and VA are insured and guaranteed by the federal government in case the borrower defaults. Although down payments for conventional mortgages can be as low as 3.5%, the lender will insist on private mortgage insurance (PMI) so they’re covered in case of default. These monthly premiums are added to loan repayments and make them much higher. Many lenders don’t require mortgage insurance for down payments of 20% or more and will cancel the need for it when your loan-to-value ratio reaches 78%.
Conforming or non-conforming mortgages
Conforming mortgages have stringent eligibility criteria which satisfy the underwriting requirements of the Federal Housing Finance Agency (also known as Fannie Mae or Freddie Mac.) This protects both lenders and borrowers from unacceptable risk. However, mortgages are as different as the people who want to buy real estate, and there are a number of non-conforming mortgages. These include loans for:
- borrowers with poor credit
- home buyers who have recently filed for bankruptcy
- borrowers with a high debt-to-income ratio
However, the most common non-conforming mortgage is called a jumbo mortgage. This is when the price of the real estate is larger than the limits set, and so it becomes a risk for the lender because of its size. For 2018, this limit has been set as $424,000 for most parts of the United States, but it is $635,000 for areas classed as high-cost areas for property purchases.
Jumbo mortgages require a down payment of at least 15-20%, and you should have a proven track record of good money management skills as seen by a high credit score. The main drawback of non-conforming mortgages is that they might not be offered by all lenders limiting where you can apply. Their other disadvantage is that they all have much higher interest rates than conventional mortgages.
The pros and cons of balloon mortgages
Balloon mortgages are quite a specialized financial product. Although they operate like fixed rate mortgages, they have a much shorter term. The way that they work is that borrowers mainly pay off the interest in their monthly installments, but at the end of the loan term, they have to pay off a balloon payment (in the form of a large lump sum).
Balloon mortgages are quite a specialized financial product suitable for people who are disciplined with money.
This type of mortgage is only suitable for people who are disciplined with money, who want to sell the property before the balloon payment becomes due and/or whose income is more erratic. For example, they might receive large bonuses which allow them to make extra payments over the loan term. They are more often seen for commercial rather than residential property. Lenders are reluctant to award these types of mortgage unless borrowers can prove that they have other sizable assets and have a good credit record. There’s also an element of risk with balloon mortgages if your financial planning doesn’t work out, and you’re incapable of meeting the large payment. Refinancing through the original lender can be extremely costly.
Conclusion – Which mortgage to choose?
Which mortgage you choose to take out to finance your home purchase depends on many factors. You should do your homework and become familiar with all the different types so you’re able to weigh up all their pros and cons. Most lenders will be happy to talk you through your options when you contact them in the initial stages. This will ensure that you get the right mortgage for your personal and financial situation.