Your Choice of Mortgage: Basics and Variations

Once you know some of the basics about mortgages, you can more closely examine the different types. You should familiarize yourself with two basic kinds of mortgages before we get to some of the more exotic variations.

Fixed-Rate Mortgage

This is the plain-vanilla loan that most people think of when considering a mortgage. You will owe a certain percentage of the loan as interest to the lender. This amount never changes, and your monthly payment will remain the same over the life of your loan. Fixed-rate mortgages are usually for 15 or 30 years.

ARM

No, not the thing hanging from your shoulder. This is an "adjustable-rate mortgage." The interest rate changes to reflect changes in the credit market out in the great, wide world.

The first-year rate (otherwise known as the teaser rate) is generally a couple of percentage points below the market rate. There are also upward limits, above which the interest rate isn't allowed to go -- this is called the cap. If your teaser rate is 4%, and you have a five-point cap, then the highest that your interest rate can go is 9%.

What's more, the amount that the interest rate can rise each year is limited, usually to one or two percentage points per year. The frequency at which the rate adjusts might vary; make sure you know these features.

If you're considering an ARM, think about the worst-case scenario. What if interest rates go up, and your ARM adjusts to its maximum? What will that maximum be, and when will it kick in? Will you be able to afford the payments?

And that, folks, is it: the two major types of loans.

COFI, Anyone?
One type of ARM is a COFI loan. COFI stands for "cost of funds index." This loan doesn't have any caps, and adjusts monthly. It is, in a sense, the most adjustable ARM of all, since it isn't fixed for a certain time. But the index to which it is tied is in many ways the most stable index of them all: It is tied to the rate that banks have to pay their depositors to keep their money (i.e., checking accounts, savings accounts, certificates of deposit). It tends to be a slow-moving index. The COFI loan has c ertain advantages in that you can vary the amount of your payments as you wish (paying off more or less each month). If this suits your temperament and your budget, inquire about it since it is often not brought up as an option.

Hybrid Loan
Just as in a candy store, why have two flavors when we can have a mix and make three? Sure, your hands may get sticky and your tongue can turn green, but we like freedom of choice. Typically a hybrid loan is fixed for 1, 3, 5, 7, or 10 years and then conv erts to an ARM. This means you get stability for a given amount of time, and then your fate is cast to the winds of the prevailing interest rates. If you imagine a fixed-rate mortgage as a motorboat, and an ARM as a sailboat, then you get to run the ship under its own engines for a time before you unfurl those sails and hope for favorable winds.

Two-Step Loans
These loans attempt to have the best of both worlds: the stability of a fixed loan with the lower rates of an ARM.

They appear in their most common forms as 5/25 or 7/23 loans. Math buffs among you will note that the numbers straddling those slashes add up to 30, as in a 30-year loan. This means that your interest rate will be fixed for the first five or seven years, then the loan adjusts in one of two ways: It will either become an ARM, adjusting annually, or a fixed-rate loan. The beginning interest rate for these loans is generally lower than that of a standard 30-year fixed loan.

Balloon Loans
These tend to be short-term loans. You borrow money for, say, three or seven years, and the loan is amortized as though it were a 30-year loan. At the end of the three- or seven-year period, you owe the bank all of the remaining principal, in one lump sum -- like a big balloon. Again, these loans tend to have lower interest rates than the standard 30-year mortgage. If you're not planning to stay too long in your house, you might be interested in such a loan. The reasoning goes like this: You pay less in interest -- saving potentially thousands of dollars -- over the course of the loan than you would with a 30-year fixed. So you're less out-of-pocket when it comes time to sell.

Keep in mind, though, that if for some reason your plans change and you want to stay in the house, you're going to have to pay off the loan in full -- by getting another loan, at the prevailing interest rates, and with the attendant costs of getting that new loan. So it isn't for the faint of heart or irresolute of mind.

Pros and Cons
To review: There are two main loan categories -- fixed- and variable-rate. What are some of the pros and cons of these two main types?

Fixed-Rate Mortgage
Pro: You can determine exactly how much you're going to pay each month for the next 30 years.

Con: You will pay a premium for this predictability. This loan will generally cost more than an ARM.

Tip: Get a fixed-rate mortgage if stability is important to you or you're less than confident about the economy or your job security. (If it's the latter, you ought to have a nice nest egg stashed away.)

Adjustable-Rate Mortgage
Pro: Because the interest rates are lower for this type of loan, it's easier to borrow more. This is often important to first-time home buyers who are already stretching the limits of what they can afford.

Con: If interest rates rise you could be up the creek without a paddle -- if you haven't

Tip: Get an ARM if you're expecting to stay in your house for less than five years.

If you'd like to get an idea of what your payments would look like for a fixed or adjustable mortgage, we have a couple of toys for you to play with. Check out our Foolish calculators to find out How much will my adjustable-rate payments be? and Which is better: fixed or adjustable?

Where are you going to shop for this loan? You can get a loan from a lending institution or from a mortgage broker. What's the difference?