Shopping for a mortgage can sap the joy out of anyone’s day, but just remember there is light at the end of the tunnel. Once you’ve chosen a fixed- or variable-rate mortgage over 15, 20 or 30 years, the last big decision is the mortgage repayment method. There are plenty of choices to suit just about any budget, but choose wisely as this decision will impact you for many years.
Mortgages, or loans used to purchase a piece of real estate, come in many shapes and sizes. What remains common throughout is that as the borrower, you must repay the loan on a schedule set by the lender over an agreed-upon period. While most lenders require you to make monthly payments on the loan, some allow biweekly payments or additional ad hoc payments towards the principal to help lessen the length of the loan and reduce the amount of interest paid.
Principal and Interest
The most common type of mortgage repayment method is a traditional schedule of payments where the lender applies a portion towards principal and the rest towards interest. Lenders use amortization, a complicated formula with a simple concept, to determine the amount of each payment and the percentages applied towards the original loan balance and interest. After you make a payment, the lender recalculates the loan based on the new unpaid principal amount. If you have a fixed-rate mortgage, the interest rate and payment amount does not change throughout the life of the loan, although the amount applied towards principal gradually increases with each payment. An adjustable-rate mortgage, or ARM, may incur changes to the interest rate, and therefore the payments, on a schedule set by the lender.
Interest-only mortgages allow you to defer repayment of principal for a set period, usually five to 10 years. At the end of the interest-only payment period, the lender amortizes the loan based on the remainder of the mortgage term -- usually 25 years after a five-year interest-only period or 20 years after a 10-year interest-only term. Although MSN Money cautions that interest-only mortgages are “not magic,” there are benefits for the right borrowers, particularly those who expect their financial situation to improve markedly in the near future.
Balloon mortgage repayment plans allow borrowers to take advantage of much lower interest rates for a specified period, usually three to 10 years. At the end of this initial term, the lender calls in the entire balance of the mortgage via a balloon payment. When the balloon payment is due, borrowers usually repay the loan through refinancing the mortgage or selling the property. There are risks, especially if the home’s value depreciates or interest rates skyrocket, but this is an appealing mortgage for people who do not expect to stay in their home long-term.
Minimum or Limited Payments
Minimum payments are the attraction of Option ARMs. The repayment method is similar to that of an interest-only mortgage, but borrowers pay only a portion of the interest accrued during that period. The lender tacks the remainder of the interest due onto the original loan balance. Instead of the original loan amount decreasing, as with a principal and interest payment, or remaining stable, as with an interest-only payment, the original loan balance grows over time. Not only is this one of the riskiest types of mortgage repayment methods you could sign on for, Bloomberg’s Businessweek has gone so far as to dub them “nightmare mortgages.”
- The Mortgage Professor's Web Site: Mortgage Amortization
- MSN Money: Interest-Only Loans -- Not Magic, Usually Not Smart
- BankRate.com: Other Types of Mortgages
- The Federal Reserve Board: Interest-Only Mortgage Payments and Payment Option ARMs
- BankRate.com: Balloon Mortgages
- Bloomberg BusinessWeek: Nightmare Mortgages
- Jupiterimages/Comstock/Getty Images
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