Let's start with you imagining being on the phone with me and I ask you, 'do you know what kind of loan do you want?' Your respond with: 'Well, I don't want an interest only loan.' I ask, 'Okay, why not?' 'Well,' you say, 'because I want a fixed payment, I don't want my payment to change.' I ask, 'okay, do you know when or how it changes if you would in fact get this loan?' You say, 'Well, I think it would change in a few years and I'd get a lot higher payment.' 'Well, sort of' I say. I also ask, 'do you think the interest rate changes with this loan?' You say, 'Well, I'm not sure.' And I say, 'Okay, let me explain the differences between the three loan types that I can offer you.' (This is an example of a conversation I've had hundreds of times in my mortgage career.
In this article, I'm going to try to clear up the misinformation about these loan programs and say something about why you might pick one over the other so you can pick the loan program that best fits your short and long term needs.
Let's start with the interest only loan. The interest only loan has a fixed interest rate for the life of the loan, which is typically 30 years. Unlike the fixed rate mortgage where you pay principle and interest, for the first 10 years of the interest only loan you'll only have to pay the interest payment. Thus, the monthly payment for the interest only loan is a little lower than the payment for a fixed rate mortgage. One of the benefits of this type of payment program is that if you pay some principle in addition to the interest only portion, your monthly payment will go down. One reason why someone takes this loan is that they want to divert some of the money they would pay into the principle into paying off other types of debt like credit cards, or to contribute more money into a retirement account.
At the end of 10 years, your payment will jump up to equal whatever your payment would be to pay the loan off over the next 20 years. It's hard to tell what it would jump to because it is based on the loan balance you have at 10 years. If you had paid any principle this would reduce your overall monthly payment.
Very few people ever keep this loan for the full 10 years of the interest only period. Most people either refinance or sell their property before the 10 years is up. The average time in the US that someone holds their mortgage is somewhere around 5 years. For more information on this loan program refer to 'Are Interest Only Loans Bad' which is an article found on GetPreQualified.com.
Next the adjustable rate mortgage (ARM). Typically, these loans have a fixed period and then at the end of the fixed period the payment can change based on what interest rates at that time, relative to how interest rates were when you got your mortgage. Most of these loans have a fixed payment period of 1, 2, 3, 5, 7, or 10 years. Most of the time, ARM's have lower interest rates for the fixed period than their counterpart fixed rate mortgages at the time that you get your mortgage. This is why someone would take this type of loan. They want a lower rate with a shorter fixed period because they don't necessarily intend on keeping the loan or the property very long. The risk in the loan program is if you can't refinance or sell the property at the end of the fixed period. If this happened you'd then be faced with a changing monthly mortgage payment and you'd have to be ready for the payment to go up if the mortgage interest rates at that time were higher than when you originally got your loan. One great possibility with this loan is that your monthly payment could down at the end of the fixed period if interest rates were better than when you first got the loan.
Last but not least, the fixed rate mortgage. These mortgages are the most stable and safe mortgages to have. Many of our parents and grandparents had this loan, as do many homeowners today. The interest rate stays the same; the payment stays the same throughout the loan. Unlike during the interest only loan, if you pay extra on this loan, your payment won't go down, it will remain the same. What will happen if you make extra payments is that you'll pay the house off earlier. This loan is appropriate if you don't want to risk changing mortgage payments in the future and you plan to stay in the home for a long period of time.
I hope what I have covered in this article answers some of your questions about what loan type is right for you. For more information on loan programs, see the loan program section on www.GetPrequalified.com, or search the internet for Mortgage Loan Programs.
Article by Dale Stouffer, Mortgage Broker
