Loan Types

There are many different types of mortgage loans and many terms used by mortgage lenders to describe them. There are two basic types of loans and all the rest are variations.

The basic loan types are:

Fixed-Rate Loans
This is the most common and least complicated mortgage loan type. You basically borrow a certain amount of money and pay a non-changing interest rate on it. This means that your monthly payment never changes during the course of the loan. Fixed-rate mortgages are typically for 15, 20 or 30 years.

ARMs
ARM stands for adjustable rate mortgage. It means that the rate will adjust as interest rates change in accordance to a specific index. So if interest rates rise, then so will your interest rate. If they drop, then your interest rate goes down too.

An ARM usually has a below-market interest rate (or teaser rate) during the first year of the mortgage. An ARM also has a limit on how high the interest rate can rise or drop. This is called the cap. So, if you start out with a 5% ARM with a 5-point cap, then the highest your interest rate can rise to is 10%.

Most other loans are combinations of fixed-rate loans and ARMs. Here are some of those other types of loans:

COFI Loans
COFI stands for Cost of Funds Index. COFI loans are ARMs in the truest sense of the word. They adjust every month and have no caps and at no time is a COFI loan fixed. This type of loan may not seem very good, but these loans are tied to a very stable index. The cost of funds index is the rate that banks pay people to keep their money in their bank. The main advantage to this kind of loan is that you can vary your payments. Ask a mortgage lender about this type of loan because they often will not mention it.

Hybrid Loans
Hybrids loans are a combination of fixed-rate loans and ARMS. These loans are fixed for a certain amount of time and then convert to an ARM. Sometimes they will offer a low fixed rate, but that is usually only the case when they believe that the interest rate will go up after the initial fixed period.

Two-Step Loans
These loans attempt to give you the stability of a fixed loan along with the lower rates of an ARM. Typically, they appear as 5/25 or 7/23 loans. In these loans, the interest rate is fixed for part of the loan. Here is how this works. Let's take a 5/23 loan as our example. For the first 5 years the interest rate is fixed. Then, after the 5-year fixed period, the loan can either become an ARM or become a fixed-rate loan at a new interest rate since the initial rate is lower than that of a typical fixed-rate mortgage.

Balloon Loans
This kind of loan works well if you do not intend to stay in your house for a long time. Balloon loans are intended to be short-term loans. Here is how it works. You borrow money for a short period of time at a lower interest rate (typically this can run for about 3-7 years). You pay interest on the loan as if you had a regular loan, but after the end of the borrowing period you are expected to pay the remaining principal in one lump sum. This means you will have to sell the real estate to pay off the loan or obtain a new loan at prevailing rates.