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CHAPTER 4. Choosing the Right Type of Mortgage

Twenty-five years ago this chapter would have been very short. You could choose from only a few types of mortgages. Today, however, many are available, and new types of mortgages are being invented all the time. This chapter describes the mortgage products that are most popular and widely offered, and it gives the advantages and disadvantages of each type:

• Traditional 30-year, fixed-rate mortgages

• 15-year, fast-payoff mortgages

• Graduated-payment mortgages

• Interest-only mortgages

• Adjustable-rate mortgages

• Payment option ARM

• Balloons, 3/1 ARMs, and two-Steps

• FHA, VA, and conventional loans

Fixed-Rate Mortgages

Fixed-rate mortgages include not only the traditional 30-year loan that most people are familiar with but also 15-year loans, graduated payment mortgages, and interest-only mortgages. With all of these mortgages, your interest rate remains the same throughout the life of the loan.

Traditional 30-Year Mortgage

With the traditional 30-year mortgage, the rate does not change, the payment does not change, and in 30 years, it is all paid off. This is the most popular mortgage, and when interest rates are less than 10 percent, most borrowers should get the traditional 30- year mortgage.

With a $100,000 30-year mortgage at 8 percent, you would pay $733.77 principal and interest (P&I) per month. A portion of the P&I payment is the interest on your loan. The remainder of the payment reduces the loan's outstanding principal balance, slowly repaying the entire loan. Loans that are repaid gradually over their life are called amortizing loans. The loan amortization chart in Figure 4.1 for a $100,000 loan at 8 percent shows the remaining principal balance over the life of the loan.

You repay very little principal in the early years; at the end of ten years, your remaining loan balance is still $88,000; at the end of 20 years, $61,000; at the end of 30 years, it is paid off. Appendix J contains amortization tables for loans with terms from 5 to 40 years and interest rates of 2 percent to 19 percent.

Advantages. The main advantage of the traditional fixed-rate mortgage is certainty that your rate and your monthly principal and interest payments do not go up. Your payment stays the same for 30 years.

Disadvantages. If overall interest rates go down, as they did in the early 1990s and again in 2000 to 2004, your rate on a traditional mortgage does not go down with them. To take advantage of lower interest-rate levels, you have to refinance, and that may cost thousands of dollars. Many people who bought homes in the early 1980s with fixed-rate loans at 14 percent and 15 percent refinanced in early 1985 to new fixed-rate loans at 12 percent. Then they faced the prospect of paying even more to get the 10-percent loans being offered in 1986. In the early 1990s, lenders introduced zero-point and no-cost refinance loans that enabled many borrowers to refi-

FIGURE 4.1 Amortization Chart for a Traditional 30-Year, Fixed-Rate Mortgage

Amortization Chart for a Traditional 30-Year, Fixed-Rate Mortgage

nance repeatedly without adding to their loan balances or facing extraordinary out-of-pocket costs. This was helpful when interest rates fell again at the beginning of the millennium. (See Chapter 8, “Refinancing,” for a fuller discussion.) A fixed-rate loan is a two- edged sword: It is good when rates go up, but bad when rates go down.

 
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