Pros and Cons of Different Mortgage Program Types
A mortgage is always made up of three different elements: the loan type, the loan term and the interest rate type. Let’s take them one by one.
1) Loan Type
Mortgage loans are organized into categories based on the size of the loan and whether they are part of a government program.
This choice affects:
- How much you will need for a down payment
- The total cost of your loan, including interest and mortgage insurance
- How much you can borrow, and the house price range you can consider
Choosing the right loan type
Each loan type is designed for different situations. Sometimes, only one loan type will fit your situation. If multiple options fit your situation, try out scenarios and ask lenders to provide several quotes so you can see which type offers the best deal overall.
- Conventional – These are one of the most common loan types and can signify a variety of loan types
- FHA – These loans require lower down payments and/or lower credit scores
- VA – For veterans, servicemembers, or surviving spouses
- USDA – For low to middle-income borrowers rural, geographically restricted areas
2) Loan Term
The term of your loan is how long you have to repay the loan. This choice affects several things:
- Your monthly principal and interest payment
- Your interest rate
- How much interest you will pay over the life of the loan
In general, the longer your loan term, the more interest you will pay. Loans with shorter terms usually have lower interest costs but higher monthly payments than loans with longer terms.
There are two reasons shorter terms can save you money:
- You are borrowing money and paying interest for a shorter amount of time
- The interest rate is may be significantly lower
Tradeoffs With Loan Term Options
| SHORTER TERM | LONGER TERM |
|---|---|
| Higher monthly payments | Lower monthly payments |
| Typically, lower interest rates | Typically, higher interest rates |
| Lower total cost | Higher total cost |
3) Interest Rate Type
Interest rates come in two basic types: fixed and adjustable. Which type you choose will affect a few things:
- Whether your interest rate can change
- Whether your monthly principal and interest payment can change and by how much
- How much interest you will pay over the life of the loan
Your monthly payments are more likely to be stable with a fixed-rate loan, so you might prefer this option if you value certainty about your loan costs over the long term. With a fixed-rate loan, your interest rate and monthly principal and interest payment will stay the same. Your total monthly payment can still change—for example, if your property taxes, homeowner’s insurance, or mortgage insurance goes up or down.
Understanding Adjustable-Rate Mortgages (ARMs)
Adjustable-rate mortgages (ARMs) offer less predictability but may be cheaper in the short term. You may want to consider this option if, for example, you plan to move again within the initial fixed period of an ARM. In this case, future rate adjustments may not affect you. However, if you end up staying in your house longer than expected, you may end up paying a lot more. In the later years of an ARM, your interest rate changes based on the market, and your monthly principal and interest payment could go up a lot, even double.
ARMs are described using a certain format. Most ARMs have two periods. During the first period, your interest rate is fixed and won’t change. During the second period, your rate goes up and down regularly based on market changes. Most ARMs have a 30-year loan term.
Here's how an example 5/1 ARM would work. The first number, 5, is the number of years your initial interest rate will stay fixed. The second number, 1, is the how often (in years) your rate will adjust after the fixed period ends. Common fixed periods are 3, 5, 7, and 10 years. The most common adjustment period is 1, meaning you will get a new rate and new payment amount every year once the fixed period ends.
ARMs can have other structures. Some ARMs may adjust more frequently, and there’s not a standard way that these types of loans are described. If you’re considering a nonstandard structure, make sure to carefully read the rules and ask questions about when and how your rate and payment can adjust.
Tradeoffs With Interest Rate Options
| FIXED RATE | ADJUSTABLE RATE |
|---|---|
| Lower risk, no surprises | Higher risk, uncertainty |
| Higher interest rate | Lower interest rate |
| Rate does not change | After initial fixed period, rate can increase or decrease based on the market |
|
Monthly principal and interest payments stay the same |
Monthly principal and interest payments can increase or decrease over time |