There is basic terminology that is important to understand before I write about mortgages.

Conventional loans are loans that are neither insured nor guaranteed. They are loans with amounts below the maximum amount set by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddy Mac) for a single family (see Table 1).  Fannie Mae and Freddy Mac are the major purchasers of mortgages from the loan brokers or originators, and so they set the standard as to the type of loans they will purchase. This maximum amount changes year to year. Conventional loans require Private Mortgage Insurance (PMI) if the down payment is less than 20 percent. PMI is insurance that guarantees payment to the lender should you fail to make payments. Borrowers can eliminate PMI by having equity greater than 20 percent.

Table 1

Coventional Loan Limits for Fannie Mae and Freddic Mac (Single Family)

2006                                          $417,000

2007                                          $417,000

2008                                          $417,000

2009                                          $417,000

2010                                          $417,000

Loan limits are 50% higher in Alaska, Guam, Hawaii, and the US Virgin Islands

Jumbo loans are loans in excess of the maximum eligible for purchase by the two Federal Agencies, Fannie Mae and Freddy Mac, of $417,000 in 2010 (note that Alaska and Hawaii are double this amount). Some lenders also use the term to refer to programs for even larger loans, such as loans in excess of $500,000

Piggyback loans are two separate loans, one for 80 percent of the value of the home and one for 20 percent. The second loan has a higher interest rate due to its higher risk. The second loan is used to eliminate the need for Private Mortgage Insurance, the cost of which can be substantial.

There are eight main types of mortgage loans available in the United States: fixed-rate mortgages (FRMs), variable- or adjustable-rate mortgages (ARMs), variable or fixed interest-only mortgages (IO), option adjustable-rate mortgages (Option ARMs), negative-amortization (NegAm), balloon mortgages, reverse mortgages, and special loans.

Fixed-rate mortgages (FRMs): FRMs are mortgage loans with a fixed rate of interest for the life of the loan. These are the least risky type of mortgage from the borrower’s point of view because the lender assumes the major interest-rate risk above the loan rate.  For many years, this was the most common type of mortgage.

The benefits of fixed-rate mortgages include higher initial monthly payments (a greater percentage of payments go to pay down principal), no risk of negative amortization, and interest-rate risks that are transferred to the lender. The risks include higher interest rates (lenders must be compensated for increased interest-rate risk), and higher monthly payments that are more difficult to pay, particularly for those not on a regular salary.

Variable- or adjustable-rate mortgages (ARMs): ARMs have a rate of interest that is pegged to a specific interest rate index that changes periodically; they also have a margin that is set for the life of the loan. Generally, the interest rate is lower than that of a fixed-rate loan initially because the borrower assumes more of the interest-rate risk. However, due to the risk of rising future interest rates, ARMs may result in significantly higher interest rates in the future. ARMs may have a fixed rate for a certain period of time, such as one, three, or seven years, and then afterwards the interest rate adjusts on a periodic basis.

The benefits of variable-rate loans include lower interest rates that vary with national interest rates initially, lower monthly payments (because interest-rate risk is assumed by the borrower), and no risk of negative amortization. The risks include a possible “payment shock” if interest rates rise, perhaps beyond what borrowers are able to pay, and somewhat higher monthly payments that may be difficult for those not on a regular salary.

Fixed or variable interest-only loans: Interest-only loans are FRMs or ARMs with an option that allows the borrower to make interest-only payments for a certain number of years; payments are then reset to amortize the entire loan over the remaining duration of the loan. Some borrowers will take out an interest-only loan to free up principal to pay down other more expensive debt. However, once the interest-only period has passed, the payment amount resets, and the increase in payment can be substantial. For example, a five-year interest on a thirty-year fixed loan has a five-year period when payments are interest-only. However, at the end of five years, the payment resets to fully amortize the entire loan but now it is over twenty-five years, resulting in a major increase in payments.

The benefits of fixed or variable interest-only loans include lower initial monthly payments and greater flexibility; these benefits may be helpful if the borrower could better use his or her money elsewhere. Because borrowers only pay interest costs (and not principal), they can afford higher loan amounts to buy more house, with the expectation that they may move before the payments increase. The risks of this kind of loan include a major rise in payments when the interest period ends; also, there is no amortization of principal during the initial interest-only period. For example, if a borrower takes out a fixed rate interest-only mortgage with a ten year interest-only option, the borrower pays interest for the first ten years. In year eleven, however, the borrower must pay substantially higher payments as the loan now must amortize over 20 years instead of the normal 30 years. The borrower must assume appreciation of the house to make money. The main risk of interest-only loans is that many borrowers do not have the discipline to invest savings from principal, and so they spend it.  In addition, there is the risk of borrowing too much money because of the lower initial payments.

Option adjustable-rate mortgages (option ARMs): In an option ARM, the interest rate adjusts monthly, and payments adjust annually; there are “options” on the payment amount, and there is a minimum payment option, which may be less than the interest-only payment. The minimum payment option often results in a growing loan balance (termed negative amortization), which has a specific maximum for the loan, i.e., 110% or 125%. Once this maximum is reached, payments are automatically increased. The loan becomes fully amortized after five or ten years, regardless of the increase in the amount of principal and interest payments.

The benefits of option ARMs initially include lower initial monthly payments and greater flexibility; these benefits are especially appealing if borrowers have better use for their money elsewhere. Borrowers can afford more house, and they may move before the payments increase. The risks of option ARMs include major “payment shock” when the negative amortization or option period ends and the payment is reset. there is the risk that the borrower will borrow too much money.  There is also the risk that monthly payments will be insufficient to cover principal and interest costs, and the difference, called negative amortization, is added to the loan principal. This type of loan should be used very carefully and is highly risky for borrowers.

Negative-amortization mortgages (NegAm): Negative-amortization loans are mortgage loans in which scheduled monthly payments are insufficient to amortize, or pay off the loan. Interest expenses that have been incurred, but not paid, are added to the principal amount; this process increases the amount of the debt. Some NegAm loans have a maximum negative amortization that is allowed. Once that limit is reached, rates adjust automatically to ensure that interest is sufficient to not exceed the negative-amortization limit.

A benefit of NegAm mortgages is that borrowers do not have to make full payments on the loans, and hence they conserve cash. The risk is that borrowers may find that they are at the negative-amortization limit where payments are automatically reset to a level higher than they can afford.

Balloon mortgages: Balloon mortgages are mortgage loans whose interest and principal payment won’t result in the loan being paid in full at the end of the term. The final payment, or balloon, can be very large. These loans are often used when the debtor expects to refinance the loan when it approaches maturity.

The benefit of balloon mortgages is that borrowers do not have to make full payments on the loans, and hence they conserve cash. The risk is that the borrower may get to the end of the payments period and not be able to come up with the required balloon payment.

Reverse mortgages: Reverse mortgages are mortgage loans whose proceeds are made available against the homeowner’s equity. In essence, financial institutions purchase the seller’s home and allow the seller the option of staying in the home until he or she dies. Reverse mortgages are typically used by cash-poor but home-rich homeowners who need to access the equity in their homes to supplement their monthly income at retirement.

The benefit of these mortgages is that the homeowners have an increased income stream to use for retirement, and they can stay in their homes until they die. The disadvantage is that if death occurs soon after the loan is closed, the lender has purchased the house for a very low cost.

Special loans: Special loans are loans that are insured or guaranteed. Insured loans are loans that are issued by others but insured by a federal agency. The FHA (Federal Housing Administration) does not originate any loans, but insures the loans issued by others based on income and other qualifications. With an FHA loan, there is lower PMI insurance, but it is required for the entire life of the loan (1.5 percent of the loan). While the required down payment is very low, the maximum amount that can be borrowed is also low.

Guaranteed loans are loans issued by others but are guaranteed by a federal agency. The Veterans Administration (VA) guarantees loans issued by others. These loans are only for ex-servicemen and women as well as those on active duty. These loans may be for 100 percent of the home value.