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Types of Home Purchase Loans

The vast majority of homeowners have purchased their home using a loan granted by a bank. There are three basic types of loans that you should know:

(1) Fixed-Rate Mortgage (2) Interest Only Mortgage (3) Adjustable Rate Mortgage (ARM)

Fixed-Rate Mortgage – Fixed-Rate Mortgage

A fully amortizing mortgage in which the interest rate on the loan remains constant throughout the term of the loan. In a fixed-rate mortgage, the monthly mortgage payments remain constant. The principal in each monthly mortgage payment increases over the life of the loan until the loan is fully amortized. The fixed-rate mortgage is the most commonly used type of mortgage to purchase a home.

Interest Only Mortgage – Interest Only Mortgage

A direct, non-amortizing loan in which the lender receives only interest during the term of the loan, and the principal is paid in a lump sum at maturity. In an interest-only mortgage, the monthly mortgage payments consist exclusively of interest (no principal) and remain constant. The loan is NOT amortized over the life of the loan. The entire loan amount must be paid in full on the due date. An interest-only loan is riskier than a fixed-rate mortgage, since the entire loan amount must be repaid at maturity.

Advantages of Interest Only Mortgages:

  • Lower monthly mortgage payments compared to a fixed-rate mortgage.

Disadvantages of Interest Only Mortgages:

  • The borrower is responsible for paying the full amount of the loan when due (you can pay cash, refinance the property, or sell the property).
  • The borrower is at greater risk of default if he or she is unable to repay the entire loan amount when due.

Adjustable Rate Mortgage – Adjustable Rate Mortgage (ARM)

A mortgage loan that has an interest rate that is subject to change during the term of the loan, whether predetermined or not.

For an adjustable-rate mortgage, the initial monthly mortgage payments are calculated as if the loan were a 30-year fixed-rate mortgage. The monthly mortgage payment increases once the interest rate adjusts and continues to increase until the interest rate cap is reached. The loan is fully amortized over the life of the loan, but the borrower pays significantly more in interest compared to a fixed-rate mortgage.

EXAMPLE (7/1 ARM) Loan Amount: $250,000 Term: 30 years Interest Rate: 5.00% Interest Rate Limit: 12.00%

BASIC CHARACTERISTICS OF AN 'ARM' Loan Term: The length of the loan (in years) over which the loan is fully amortized. Initial Interest Rate: The initial interest rate of the loan. Adjustment Period: An ARM can be expressed as 3/1, 7/1, 10/1, etc. The first number refers to the number of years during which the initial interest rate remains constant. After that period, the interest rate adjusts based on the index. Index Rate: Most lenders tie changes in ARM interest rates to an index rate. ARM interest rates are based on a variety of indices, the most common being rates on one-, three-, and five-year Treasury securities. Margin: The percentage points that lenders add to the index rate to determine the ARM's interest rate. Interest Rate Cap: The maximum interest rate on the loan at any time during the life of the loan.

FIXED RATE MORTGAGES ARE THE SAFEST FOR BORROWERS AS THEY ARE CONSTANT AND ALLOW THE BORROWER TO PLAN A BUDGET AROUND THE FIXED COST.

ADJUSTABLE INTEREST RATE MORTGAGES ARE THE MOST RISKY FOR HOMEOWNERS AS THE MONTHLY MORTGAGE PAYMENT CHANGES AT AN UNPREDICTABLE RATE, MAKING PAYMENT PLANNING DIFFICULT.

EXAMPLE Loan Amount: $250,000 Term: 7 years Interest Rate: 5.00% Months Before First Adjustment: 84 months Months Between Adjustments: 12 months Expected Rate Adjustment: 0.25%

Legal and Tax Disclaimer

Please be advised that the content presented in this blog is for informational purposes only and should not be construed as legal or tax advice. The articles and information provided here are written from the perspective of a real estate agent affiliated with Keller Williams, and do not represent legal or tax counsel.

As the author, I am a licensed real estate professional under Keller Williams, holding Brokerage DRE License Number: #02197031. However, it is important to note that my expertise is in the field of real estate, and not in legal or tax matters. The insights and opinions shared on this blog are based on my experiences and knowledge in the real estate industry and should be treated as general guidance rather than definitive legal or tax advice.

For specific legal or tax concerns relating to any real estate transactions or investments, readers are strongly encouraged to consult with a qualified attorney or tax advisor who can provide tailored advice based on your individual circumstances and the latest legal and regulatory requirements.

The information on this blog is provided "as is" without warranty of any kind, and I, along with Keller Williams and its affiliates, disclaim all liability for any loss, damage, or misunderstanding arising from reliance on the information contained herein.

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