Understanding Mortgage Types

To quote a mortgage broker: "There is a different loan for a different need." In other words, the type of mortgage you get depends on your individual situation. A good lender will get a sense of your needs from your credit report, your assets, and your employment history. He can then recommend some options for you. Here's a rundown on the most common loan types.

Fixed-Rate Mortgage

Interest is fixed for an amount of time; e.g., 10, 15, 20, 30, or even 40 or 50 years, at which point the amortized principal is paid in full.

Pros: Security. You know what your payments will be. You can refinance if rates drop significantly.

Cons: If rates go down, you'll still be paying the initial rate unless you refinance. This is a long-term prospect; if you are keeping your home for 15 or even 30 years, it's a conservative way to go. But you can end up paying more short-term than if you had an ARM.

Watch out: This is a long-term prospect; if you are keeping your home for 15 or even 30 years, it's a conservative way to go. But you can end up paying more short-term than if you had an ARM.

Adjustable-Rate Mortgages (ARMs)

The interest rate fluctuates with an indexed rate plus a set margin; adjustment intervals are predetermined. Minimum and maximum rate caps limit the size of the adjustment.

Pros: Initial rates are lower than fixed. Popular with those who aren't expecting to stay in a home for long, or in a hot market where houses appreciate quickly, or for those expecting to refinance. You can qualify for a higher loan amount with an ARM (due to the lower initial interest rate).

Cons: Always assume that the rates will increase after the adjustment period on an ARM. You are betting that you'll save enough initially to offset the future rate increase.

Watch out: Check out the frequency of the adjustments. The more often, the lower the starting rate, but the more uncertainty. The less often, the higher the rate, but a little more security. Check the payments at the upper limit of your cap (your rate can increase by as much as 6 percent!); you can get burned if you can't afford the highest possible rate. And planning that a refinance will bail you out is risky; what if you can't afford (or can't qualify that when the time comes?

1-yr. Treasury ARM

The rate is fixed for one year, then becomes adjustable every year. The new rate is determined by the treasury average index plus the loan margin (usually 2.25-2.5%). 30-yr. term

Pros: Lower rates than a fixed mortgage. When rates go down, you benefit.

Cons: Watch the margin; the margin is added to the index to come up with the new rate after the adjustment period. When rates are going up, you could end up paying more interest than with a fixed.

Watch out: If you are a gambler and think the rates won't increase, this might work for you. But if you are into it for the long or even intermediate run, fluctuating interest rates can mean higher payments over time.

Intermediate ARM

With an intermediate or hybrid ARM, the rate is fixed for a period of time, then adjusts on a predetermined schedule. This is shown by the number of years the loan is fixed, and the adjustment interval (.e.g., 3/1 ARM is 3 year fixed, and 1 adjustable annually). The new rate is determined by an economic index (usually treasury or treasury average index) plus the loan margin (usually 2.25-2.5%). 30-yr. term.

Pros: Lower rates than a fixed mortgage. When interest rates rise, you see more ARMs because they are easier to qualify for.

Cons: When rates are going up, you could end up paying more interest than a fixed-rate mortgage after the initial period.

Watch out: If you aren't planning to keep your house for long this might work for you because you will receive lower rates initially. Be sure to check the rate caps so you know exactly how high your payments can go. Fluctuating interest rates can mean higher payments over time.

Flexible payment option ARM

The borrower chooses from an assortment of payment methods every month. There is a "change cap" limiting how much payments can vary in a year.

Pros: Frees up cash when you need it. Good for buyers with variable incomes (e.g., salespeople who work on commission).

Cons: Some options won't cover your interest. With lower payments, your balance increases each month, and eventually your payments will increase substantially. This could lead to negative amortization.

Watch out: Eventually you will be required to pay down the principal and your payments will increase drastically. If you can't make them, you lose the house. Most experts say, "Don't do it."

Interest-only ARM

For a period of time, you pay only interest, and do not pay down the principal.

Pros: If you don't plan to stay in a home long, you can buy something you ordinarily couldn't afford. If you are in a hot market, or a hot neighborhood, you'll have low payments while your house appreciates in value. You can always pay more on the principal while enjoying the low payments.

Cons: The day will come when you need to pay down the principal. If your home value has fallen, or your income decreased, you could have trouble making the new payments.

Watch out: If you can't pay interest and principal at the same time, chances are you can't afford the house. You can only put off the inevitable for so long: the principal has to be paid down. If you can't make payments, you could lose the house. If you plan to sell your house and can't sell it for what you owe, you are in trouble.

Convertible ARM

An ARM that can be converted to fixed rate after a period of time.

Pros: Saves on refinance costs, assuming you would have been switching anyway.

Cons: You will have a higher rate for the fixed with a convertible loan. You can't look around for a better deal, which you can with a refi.

Watch out: Saving the cost of the loan and the hassle of shopping loans are a plus, but you might be crying if the refinance rates are lower than your new fixed. Experts say, "Just refinance."

Jumbo loans

Above Freddie Mac and Fannie Mae conforming guidelines , therefore the big secondary lenders will not secure jumbo loans. 2006 maximum amount for a conforming loan: $417,000.

Pros: When the market is out of sight, the jumbo loans make a purchase possible.

Cons: Higher down payments, and higher interest rates.

Watch out: If you can afford the higher payments, then go for it. But make sure you can afford them.

Assumable mortgage

An adjustable-rate loan, the balance of which can be assumed by a home buyer.

Pros: Sellers can offer a low interest rate to entice buyers.

Cons: This is almost never a fixed rate mortgage, so the savings might not be all that great.

Watch out: These are rare today. If the buyer who assumes the loan defaults, the bank will go after the original borrower.

Balloon conforming mortgage

Interest rate is fixed for a period of time, but the principal is not completely amortized. For the remainder of the term, it adjusts to a new fixed rate determined by the Fannie Mae net yield index plus the margin. 30-yr. term

Pros: Lower monthly payments initially. If your career (and salary) has a good future, or you are in a hot market and plan to sell before the balloon comes due, you can save moolah.

Cons: Who knows what that new rate will be? There's a looming debt in your future.

Watch out: You can refinance when the balloon comes due, but you are gambling that you can afford the refi loan.

Balloon mortgage

The rate is fixed for a period of time, but the principal is not completely amortized during the period. The entire balance of the principal is due as a balloon payment at the end of that period.

Pros: Lower monthly payments, with the idea you can always refi or sell before the balloon.

Cons: A big elephant waiting in the wings

Watch out: It's easy to procrastinate, or your life changes, and then your balloon pops. Refi costs might offset any savings you made.

Veteran Administration Loans

A zero-down loan offered to veterans only, the VA guarantees the loan for lenders.

Pros: Nothing down, and no mortgage insurance. The loan is assumable.

Cons: It's possible the rate is more than conventional loans or FHA loans.

Watch out: Shop around first. Lenders are getting paid a 2 percent service fee by the government, so your points should reflect a discount when compared to similar rate loans.

Federal Housing Administration Loans (FHA)

Government-subsidized loan with low down payment (i.e., as little as 1-3%) and closing fees included; the government guarantees the loan.

Pros: Low rates for those who can't come up with the down payment or have less-than-perfect credit; great for first-time homebuyers. The loan is assumable.

Cons: If you can afford 5 percent down, you might find better rates with conventional loans

Watch out: Shop around first. Lenders are getting paid a 2 percent service fee by the government, so your points should reflect a discount when compared to similar rate loans.