Financing Foundations: What Type of Mortgage Loan is Right for You?

by Redeeming Riches on March 3, 2014

Fixed, variable, interest-only. What type of loan should you get? There are so many choices out there in the marketplace. Fortunately, you don’t have to go it alone. Most lenders will tell you exactly what they sell, but it’s the real estate agent that is probably going to be your best friend when it comes time to get pre-qualified. That’s because real estate agents are in a unique position to be interested in your ability to get a loan, yet legally barred from benefiting from recommending a loan type to you.house11

Fixed Rate Loans

A basic fixed rate loan is what you’re probably most familiar with. It’s a loan that fixes the payment and the interest rate for the life of the loan. You never worry about what you’re going to pay in the future. All you have to worry about is locking in the interest rate when you apply.

Most of the top selling realtors in the U.S. recommend this type of loan for most buyers, even seasoned homeowners. It’s simple and there are no surprises with this loan.

Variable Loans

If you want to take advantage of low or falling interest rates in the marketplace, choose a variable rate loan. These loans do not fix the interest rate or payment on the mortgage. However, you do often pay less than you would with a fixed rate mortgage when interest rates are low.

There are also loan types that restrict how much the lender can increase your monthly payment, though the lender does have a lot of leeway here in this regard. It is a variable-rate loan after all.

Interest-Only Loans

Interest-only loans are often variable rate, but some of them do fix the interest rate for a set period of time. The unique feature of these loans, however, is that you are only responsible for paying the interest on the loan. You’re not responsible for paying the principal.

This means that you can either buy a bigger home or you can save money and use it to fund your future retirement savings. Most lenders do recommend you don’t overbuy a house with this type of loan, however, and instead either consider saving the difference or using the extra money to pay off the principal. These loans often switch from interest-only payments to fully amortized payments after a set number of years (i.e. 5 or 10 years, for example). These loans are good when you only expect to be living in the home for several years and plan on selling after that.

Option ARM

Option ARMs are adjustable rate loans that are very complex in their structure. They offer 4 payment options every month. You can either choose to make the minimum monthly payment, an interest-only payment, a 15-year fully amortized payment, or a 30-year fully amortized payment.

The minimum payment is so small that it doesn’t cover the cost of the interest on the loan, so interest is added to the loan amount, causing the loan to grow for the first several years. This often puts homeowners upside-down on their house. After the firs several years, the payments necessarily increase so that the loan can be paid off in 30 years. These “balloon payments” are always substantially higher than the 30-year payment since the borrower has been making only the minimum payment for several years and accumulating a larger loan balance.

Of course, you don’t have to make the minimum payment every month. But, these loans are very exotic and often reserved for complex financial planning situations. Unless you’ve already talked with a financial planner, it’s best to avoid these types of loans.

Arthur Young has a knack for numbers. With years as a financial counselor behind him, he enjoys writing about practical money matters for the everyday person.

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