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Course: Financial Literacy > Unit 14

Lesson 4: Mortgages

Types of mortgages

If you're buying a home and don't have all the cash to cover it upfront, you can take out a loan from a bank or lender. This is known as a mortgage. There are many types of mortgages: in this article, we will cover the most common ones.

Common types of mortgages

There are many kinds of mortgages out there, but the most common three are the

30

year fixed,

15

year fixed, and the 5/1 ARM. Each loan has its advantages and disadvantages and the best one for you depends on your personal circumstances.

30-year fixed mortgage

This is a very popular type of mortgage. In a

30

-year fixed mortgage, you pay back the loan over

30

years and your monthly payment stays the same. This is great if you like to plan your budget and you're planning to stay in your home for quite a while.

Let's take Mila as an example. She got a

$ 200,000

loan for her first home. With a

30

-year fixed loan with an interest rate of

6.5 %

, she'll make monthly payments of around

$ 1,264

for

30

years.

The downside of this loan is that you end up paying a lot in interest because it takes such a long time to pay back.

15-year fixed mortgage

Then there's the

15

-year fixed mortgage. This type of loan is paid off in half the time of a

30

-year loan, which results in higher monthly payments, but you pay less in interest overall because the loan term is shorter.

Let's take Ivan as example. He also got a home loan for

$ 200,000

. But he's taken a

15

-year loan with a lower interest rate of

5.25 %

(they tend to be lower because they're less risky for banks). This means every month, he'll pay about

$ 1,608

The disadvantage is that monthly payments are higher, which could be difficult for some people.

Here's a table comparing how much you would repay in total for a

30

-year fixed mortgage and a

15

-year fixed mortgage, using our examples of Mila and Ivan:

Loan type	Loan amount	Interest rate	Monthly payment	Total paid back
$30$ ‍-year (Mila)	$$ 200,000$ ‍	$6.5 %$ ‍	$$ 1,264$ ‍	$$ 455,040$ ‍
$15$ ‍-year (Ivan)	$$ 200,000$ ‍	$5.25 %$ ‍	$$ 1,608$ ‍	$$ 289,440$ ‍

On the same loan amount, Ivan will pay

$ 165,600

less than Mila.

5/1 ARM

Lastly, the 5/1 ARM, or Adjustable Rate Mortgage, is a

30

-year loan that has a fixed rate for the first five years. After that, the rate can change every year, based on the economy. There are many other ARMs, like 5/6, 7/1, 7/6, 10/ 1, and 10/6. The numbers in the names of these loans have special meanings. The first number refers to the length of time the interest rate remains fixed. The second number refers to how often the rate changes after that. Note that 1 stands for once every year, but a

6

means every $6$ ‍ months. So, a 7/6 ARM would have a fixed rate for

7

years, after which it would change every

6

months.

For example, Mario buys a house for

$ 200,000

with a 5/1 ARM. The fixed rate for the first five years is

3.75 %

(the lowest when compared to other loans), so Mario's monthly payment is about

$ 926

for that period.

The risk here is that after five years, the interest rate could increase, which would make the monthly payments more expensive. In some cases payments can even double. If you want your payments to stay the same every month, this loan might not be for you.

To sum up

In a nutshell,

30

-year and

15

-year fixed mortgages offer constant monthly payments, while with a 5/1 ARM (or any other ARM), payments start lower but change over time. Each of these loans has its own good and bad points, and knowing these can help you pick the right one considering your financial situation and your future plans.

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