Thinking of buying in 2011? Familiarize yourself with the kinds of home loans available...

Basic Types of Loans for Homebuyers

During the recent mortgage market meltdown, I spoke with dozens of distressed borrowers who were losing their homes because they had taken out the wrong types of home loans. Often they had chosen risky subprime, adjustable-rate mortgages when they could easily have qualified for safer fixed-rate loans. Attracted by minimal down payments and low introductory interest rates, they didn’t understand that their mortgage payments could rise beyond their ability to pay.

Many consumers were steered into these loans by brokers and loan officers. Today, banks and federal regulators have tightened underwriting standards, but you shouldn’t rely on others to protect you from yourself. Before you accept a loan, know your obligations. A good place to start is by familiarizing yourself with the basic types of home loans.

Fixed-rate loans came to dominate the market after the spike in foreclosures that occurred during the Great Depression. They don’t offer the low starting interest rates of adjustable loans, but they are predictable. You always know what your monthly payments will be. They are a good choice for consumers who plan to remain in their homes for a long time.

Adjustable-rate mortgages (ARMs) are more complicated than fixed-rate products. They typically start with low interest rates that last several years. This can be an advantage if you know that your income will rise or you plan to sell before the low-cost period ends. When the loan adjusts, your interest rate typically will increase. If you are not prepared, the higher payments may throw you into default.

Balloon loans have a tendency to burst unexpectedly. Sometimes called “bullet loans,” they generally start with a low interest rate. When the introductory period ends, you must pay off the loan in full. Savvy borrowers make plans to refinance before the fixed-rate period ends, but there is no guarantee that you will be able to find a more affordable loan before the deadline arrives.

The government offers a variety of loans to make homeownership more affordable. Loans guaranteed by the U.S. Department of Veterans Affairs (VA) are known for helping veterans finance with zero down payments. The interest rates typically are below those of conventional loans. Another benefit is that private mortgage insurance (PMI) is not required.

The Federal Housing Administration (FHA) typically requires a 3.5 percent down payment, unlike conventional loans, which may require as much as 20 percent down. Most FHA loans are 30-year fixed-rate products. In addition to offering low down payments, the FHA has flexible guidelines for establishing creditworthiness. It also allows down payments and closing costs to be paid through gifts or grants.

If you are a low-income buyer living in a rural area, check out the USDA Rural Housing Service (RHS), which offers low interest rates with no down payment.

The type of loan you choose should match your financial circumstances and your tolerance for risk. It is a mistake to accept anyone else’s word that a mortgage is right for you. Do your homework and be sure that you thoroughly understand your obligations.