In a word, the answer is “diversity”: among borrowers, lenders, and economic conditions.
Any type of mortgage that appears in the market in significant numbers must be broadly acceptable to both borrowers and lenders, and must fit into the prevailing economic environment. Yet some mortgage types are very clearly designed in the first instance to meet specific borrower needs; some are designed to meet specific lender needs; and some are designed to meet a special challenge posed by the economic environment.
On the borrower side, numerous mortgage types are designed to enhance initial affordability by lowering payments in the early years at the cost of higher payments in later years. These include interestonly, graduated payment and buydown mortgages. Many types of adjustable rate mortgages also have rising payment features.
Borrowers interested in paying down their loan balances as quickly as possible are attracted to biweekly mortgages, which pay off before term, and fixedrate mortgages with short terms. Borrowers who need funds intermittently, often for home modifications, are attracted to lineofcredit mortgages. Elderly homeowners may be attracted to reverse mortgages, on which they can draw funds by increasing their balances.
Lenders always look for assurances that they will be repaid, but that is the case across all mortgage types. Lenders with shortterm liabilities, which include many types of depository institutions, look for protection against interest rate risk. For this reason, they prefer adjustable rate mortgages (ARMs) and balloon loans on which rates are periodically reset. But both may include features attractive to borrowers, just as mortgage types designed to meet specific borrower needs will have features that appeal to lenders.
Interest rates in inflationary environments are so high and volatile that conventional mortgage types become impossibly costly to either borrowers or lenders. Special mortgage types have been developed that are designed to work in this kind of environment, in the sense of providing affordable payments to borrowers while allowing lenders to earn an adequate inflationadjusted returnOf these, the most common are the price level adjustment mortgage (PLAM) and the dual index mortgage (DIM). These instruments have their problems, but they keep the system functioning.
Not all mortgage types are covered in these articles, this is a work in progress. I expect to add more articles as time permits, and I also look for contributions from others, especially from outside the US, who can comment on experience abroad. In the meantime, readers are invited to peruse the many articles on the different mortgage types that appear on my web site, see Types of Mortgages.
Fixed Rate Versus Fixed Payments: An FRM is a mortgage that has no provision for changing the interest rate. Hence, the rate stated in the note is fixed for the entire term of the loan.
By prevailing practice, the term "FRM" without any modifiers means a mortgage with a fixed rate and level payments that fully pay off the balance. For example, on a $300,000 30year 6% FRM, the monthly payment is $1798.66. If the borrower makes that payment every month for 30 years, the 360th payment will reduce the balance to zero. This should be (but usually isn’t) called a "levelpayment fully amortizing FRM" to distinguish it from other types of loans that have a fixed rate but not a fixed payment. For example, one of the earliest types of fixedrate mortgages was repaid with equal monthly payments of principal, plus interest. If the loan was for $300,000 at 6% and the term was 300 months, then the payment in month 1 would be $1,000 of principal plus $1500 of interest for a total $2500. Each month the total payment would decline because interest would be calculated on a lower balance. This was the standard type of mortgage in New Zealand for many years, despite the obvious disadvantage of high payments in the early years.
A fixedrate mortgage can also have a rising payment. The version in the US is called a "graduated payment mortgage", or GPM. They have pretty much died out in the US but were the dominant type of mortgage in Portugal when I was there some years ago. The interestonly version of a fixedrate mortgage also does not have fixed payments. Borrowers begin paying only the interest, which declines if they voluntarily pay any principal, until the end of the interestonly period. At that point, the payment jumps and it becomes a levelpayment fully amortizing FRM.
Calculating the Fully Amortizing Payment: The fullyamortizing monthly payment on an FRM is calculated from an algebraic formula, those interested can find it at the Mortgage Professor website.
The much easier way is use a financial calculator, such as an HP19B, or an online calculator such as my Monthly Payment Calculator: Fixed Rate Mortgages. Technophobes can buy a book of monthly payments at a book store.
Rising Principal Payments Over Time: On an FRM, the composition of the payment between principal and interest changes every month. At the beginning, it is mostly interest but the principal portion gradually rises over time. In the example, the principal payment in month 1 is $299, in month 12 it is $316, and in month 60 it is $401.
This feature, where borrowers make the same payment every month but the saving component of the payment increases every month, is powerful but underappreciated. Some borrowers don’t recognize that debt repayment is saving, and many of those that do think they aren’t earning any return on it. I am frequently asked whether they would not do better putting their money in a bank account earning 3% than repaying their mortgage.
In fact, a principal payment of $100 on a 6% mortgage earns the same return as a $100 bank deposit that pays 6%. The deposit earns $6 a year in interest while the principal payment reduces interest payments by $6 a year. The effect on the borrower’s wealth is the same.
Of course, if you can earn 10% on your money, paying down a 6% mortgage is not the best choice. The popularity of interestonly loans in the US has been encouraged by the notion that borrowers can earn a return higher than the mortgage rate by investing their money elsewhere. In my view, however, few borrowers can earn a return above the mortgage rate without taking unacceptable risk.
Different Terms on FRMs: FRMs come with different terms, ranging generally from 10 years to 40 years. In the US, the 15 and 30year are the most popular. (In contrast, adjustable rate mortgages (ARMs) tend to have the same terms in the US, ARMs are almost all 30 years.) Shorter term FRMs usually have lower rates and amortize more rapidly, but the payments are higher.
Advantages and Disadvantages: The table below summarizes the advantages and disadvantages of FRMs to borrowers and lenders.

Borrowers 
Lenders 
Advantages 
Guarantees payment stability over the life of the mortgage 
Default rates are generally low. Simplicity and standardization encourage securitization 
Disadvantages 
Interest rate will be higher than those on mortgages with unstable payments 
Exposes lenders with shortterm liabilities to severe interest rate risk. 
The distinguishing feature of graduated payment mortgages (GPMs) is thatthe payment rises by a constant percentage for a specified number of months, after which it levels out over the remaining term and amortizes fully. The interest rate is fixed, although adjustable rate versions(GPARMs) existed for a brief period in the US during the 80s.
How a GPM Works: As an example, the mortgage payment on a $200,000 FRM for 30 years at 6% is $1,199. Stretched over 40 years, the payment would be $1,100. But the initial payment on a 30year GPM at 6.50%, on which the payment rises by 7.5% a year for 5 years, is only $941. The quid pro quo for the low initial payment is a larger payment later on. The payment on the GPM rises for 5 consecutive years, reaching $1,351 in month 61, where it stays for the remainder of the term. The initial payment on a GPM does not cover the interest. The difference, termed negative amortization, is added to the loan balance. In the example, the loan balance peaks at $202,905 in month 36 before it starts down. Not until month 61 does the balance fall below $200,000. This rising balance is a feature that lenders don’t like, and it is why they typically charge a higher rate for GPMs than for FRMs.
Alternative Types: GPMs may have different rates of payment increase over different periods. In the US. a second variant has a 3% graduation rate over 10 years instead of 7.5% for 5 years. Assuming the same 6.5% rate, the initial payment would be higher at $1,031, rising to $1,388 in month 121. Negative amortization, however, is smaller, peaking at $200,908 in month 24 In Portugal during the 80s when I was there, GPMs were the standard instrument, and the payment rose over the entire life of the loan.
GPMs Versus Temporary Buydowns: The GPM is not the only type of mortgage with rising payments. FRMs with temporary buydowns also carry lower payments in the early years. For example, the payments in the first 2 years on an FRM with a 21 buydown are calculated at rates that are 2% and 1% lower than the rate on the FRM. On a 6% 30year FRM of $200,000, the firstyear payment would be $955, rising to $1,074 in year 2 and to $1,199 in years 3–30. And the buydown loan amortizes as it would without the buydown—there is no negative amortization. For a temporary buydown to work, however, someone must fund the required buydown account. Withdrawals from this account supplement the payments made by the borrower in years 1 and 2 so that the lender receives the same payment ($1,199) throughout. The $4,436 required for the buydown account must be provided by either the borrower or the home seller. GPMs don’t require a buydown account.
GPMs Versus Option ARMs: Rising payments are also available on many types of adjustablerate mortgages, most notably on the flexiblepayment or option ARM. Under its minimumpayment option, the firstyear payment on this ARM is calculated at rates as low as 1.95%. On a $200,000 30year loan, this amounts to $734, strikingly lower than the $941 on the 5year GPM. Increases in the ARM payment, furthermore, are limited to 7.5% a year for the first 5 years, just like on the 5year GPM. In year 5, therefore, the ARM payment has risen to $980 as compared with $1,256 on the GPM. In month 61, however, the chickens come home to roost. The GPM payment rises by 7.5% one more time, to $1,351, where it stays. The ARM payment increase, on the other hand, could be 7.5%, or it could be 75% or even higher, depending on what happens to interest rates. The core difference between the GPM and the option ARM is that the borrower with a GPM knows in advance exactly how and when the payment will change. The option ARM borrower, in contrast, is throwing the dice. A new eruption of inflation is bound to cause market rates to rise markedly, which will clobber all ARM borrowers, but especially those who make the minimum payment on an option ARM. GPMs carry risk to borrowers, who must be able to meet the scheduled rise in payments, but the risk is known in advance.
Advantages and Disadvantages: The tables below summarize the advantages and disadvantages of GPMs relative to option ARMs and temporary buydowns, as alternative ways of reducing payments in the early years, at the expense of higher payments in later years.

Borrowers 
Lenders 
Advantages (Relative to Option ARMs) 
Future payment increases are known in advance. 
Default rates are lower because payment shocks are avoided. 
Disadvantages (Relative to Option ARMs) 
Payment reduction in the early years is not as large. 
Long duration makes management of interest rate risk difficult. 
The distinguishing feature of interestonly buydown mortgages (IOBMs) is that initial payments are adjusted to the income of the individual borrower, but without incurring negative amortization. In the early years, the borrower pays less than the interest, depending on income, but the lender receives the interest. The difference is made up by a withdrawal from a buydown account that is funded by either a home seller or a government agency. The interest rate is fixed. The payment increases by a preset percent every year. When the payment reaches the point where it covers the interest, the buydown account is exhausted. The payment continues to rise, however, until it becomes fully amortizing. Borrowers who begin with lower payments will face longer periods of payment increase than borrowers who begin with higher payments. There is no negative amortization. The loan balance is constant until the payment has risen to the point where it more than covers the interest. At that point, the balance begins to decline. The IOBM has been used by builders in the US to stimulate demand by home buyers who are limited in the amount of house they can buy by the mortgage payment. Contributions to a buydown account reduce the initial mortgage payment by more than a price reduction equal to the contribution. The IOBM also has potential as a costefficient subsidy tool. In contrast to interest rate subsidies that extend over the life of the mortgage, an IOBM subsidy is phased out over time. It also has the merit of requiring that the total present value of the subsidy be funded at the outset in the buydown account, as opposed to the practice of committing now to pay subsidies in the future.
The tables below summarize the advantages and disadvantages of IOBMs relative to option ARMs as alternative ways of reducing payments in the early years.

Borrowers 
Lenders 
Advantages (Relative to Option ARMs) 
Future payments are known in advance. 
Default rates are lower. 
Disadvantages (Relative to Option ARMs) 
Initial payment are not as low. 
Longer duration makes management of interest rate risk more difficult. 
The distinguishing feature of indexed adjustable rate mortgages (ARMs) is that they are subject to interest rate adjustments based on a market rate index. Such adjustments are mechanical, based on a formula. In this respect, indexed ARMs are very different from discretionary ARMs on which rates are adjusted at the discretion of the lender. Thenceforth, the term “ARM” here will be used to mean an indexed ARM.
How the Interest Rate on an ARM Is Determined: There are two phases in the life of an ARM. During the first phase, the interest rate is fixed, just as it is on an FRM. The difference is that on an FRM the rate is fixed for the term of the loan, whereas on an ARM it is fixed for a shorter period. In the US, the period ranges from a month to 10 years. At the end of the initial rate period, the ARM rate is adjusted. The adjustment rule is that the new rate will equal the most recent value of a specified interest rate index plus a margin. For example, if the index is 5% when the initial rate period ends, and the margin is 2.75%, the new rate will be 7.75%. The adjustment rule, however, is subject to two conditions. The first condition is that the increase from the previous rate cannot exceed any rate adjustment cap specified in the ARM contract. In the US, adjustment caps are usually 1 or 2% but range in some cases up to 5%. Adjustment caps limit the size of any interest rate change. The second condition is that the new rate cannot exceed the contractual maximum rate. Maximum rates in the US are usually five or six percentage points above the initial rate. During the second phase of an ARM’s life, the interest rate is adjusted periodically. This period may be but usually is not the same as the initial rate period. For example, an ARM with an initial rate period of 5 years might adjust annually or monthly after the 5year period ends.
The Quoted Interest Rate: The rate that is quoted on an ARM, by the media and by loan providers, is the initial rate—regardless of how long that rate lasts. When the initial rate period is short, the quoted rate is a poor indication of interest cost to the borrower. The only significance of the initial rate on a monthly ARM, for example, is that this rate may be used to calculate the initial payment.
The Fully Indexed Rate: The index plus margin is called the “fully indexed rate,” or FIR. The FIR based on the most recent value of the index at the time the loan is taken out indicates where the ARM rate may go when the initial rate period ends. If the index rate does not change, the FIR will become the ARM rate. For example, assume the initial rate is 4% for one year, the fully indexed rate is 7%, and the rate adjusts every year subject to a 1% rate increase cap. If the index value remains the same, the 7% FIR will be reached at the end of the third year. The FIR is thus an important piece of information, the more so the shorter is the initial rate period.
ARM Rate Indexes: Every ARM is tied to a specific rate index. Ideally, the index is compiled by an independent third party, is publicly available, and is calculated at monthly or short er intervals. Lenders prefer indexes that closely track their cost of funds, but lenderspecific cost indices that are controllable by the lender may lack credibility. If borrowers have a choice of index, as they do in the US, they prefer one that is relatively stable. A lower index also is better for a borrower than a higher one, but lenders take account of different index levels in setting the margin. A 3% index with a 2% margin provides the same FIR as a 2% index with a 3% margin. Assuming volatility is the same, there is nothing to choose between them. In the US, the most stable of the more widely used rate indexes cover the cost of funds of depository institutions. Most of the others are significantly more volatile. These include series covering US Government securities and series based on LIBOR, The most complete source of current and historical values of major ARM indexes can be found on the Web site www.mortgagex.com.
How the Monthly Payment on an ARM Is Determined: ARMs fall into two major groups that differ in the way in which the monthly payment of principal and interest is determined: fully amortizing ARMs and negative amortization ARMs.
Overcoming Complexity: Because ARMs are complex, borrowers can easily be confused. The best way for them to understand an ARM and to compare one with another is to use a payment or cost calculator. My website has six calculators in the Mortgage Payment series that show mortgage payments month by month using interest rate scenarios specified by the user. The site also has six calculators in the Comparing Two Mortgages series that compare either interest cost (an internal rate of return) or total horizon cost in dollars. The costs are calculated over the period the borrower expects to have the mortgage.
Advantages and Disadvantages: The table below summarizes the advantages and disadvantages of ARMs, relative to FRMs, to borrowers and lenders.

Borrowers 
Lenders 
Advantages 
Provides lower initial rate and payment than FRMs. 
Allows lenders with shortterm liabilities to manage interest rate risk. 
Disadvantages 
Difficult to understand. Subject to possible large future payment increases. 
Default rates are higher than on FRMs. Diversity discourages securitization 
The distinguishing feature of discretionary adjustable rate mortgages (ARMs) is that the lender has the contractual right to change the interest rate at any time, for any reason, by any amount, subject only to a requirement that the borrower be notified in advance. The discretionary ARM is at the opposite pole from indexed ARMs on which rate adjustments are completely rule based.
Discretionary ARMs were long the standard mortgage in the United Kingdom and in other Englishspeaking countries that imported it from the United Kingdom, such as India and South Africa. They never caught on in the United States because of concern that lenders would use their discretion to meet their own needs, while ignoring the needs of borrowers.
There is good reason for this concern, since the discretionary ARM was designed to allow lenders to adjust the loan rate to match their cost of funds. In the UK, this is common practice. It amounts to voluntary (as opposed to contractual) indexing, but without rate adjustment caps or maximum rates.
Lenders who write discretionary ARMs but don’t systematically adjust the rate to match their cost of funds because they don’t want to impose frequent payment changes on borrowers may be forced to makeone or more very large changes to accommodate an upward trend in interest rates. These are likely to be much more disruptive than frequent small changes. Mortgage lenders in India, after keeping rates on their discretionary ARMs stable for many years, were faced with this problem in the 90s.
Discretionary ARMs do not allow lenders to adjust loan features based on the capacity of borrowers to bear risk. On indexed ARMs, borrowers can be charged more for, e.g., a longer initial rate period, or for lower rate maximums. On discretionary ARMs, every borrower must assume the maximum risk.
Advantages and Disadvantages: The table below summarizes the advantages and disadvantages of discretionary ARMs, relative to indexed ARMs, to borrowers and lenders.

Borrowers 
Lenders 
Advantages 
Easier to understand. 
Allows lenders with shortterm liabilities to manage interest rate risk effectively. 
Disadvantages 
Borrowers are at the mercy of lenders. 
Exercise of discretion may result in high default rates. Discretion inconsistent with securitization. 
The distinguishing feature of balloon mortgages is that the interest rate is fixed, but the balance is payable in full after a period that is shorter than the term – the period used to calculate the payment.. Hence, the borrower must refinance the remaining balance at the market rate, from the same lender or a different one.
The payment on balloon loans may cover interestonly, or may include some principal as well. During the 1920s, balloon loans in the US were interest only. At maturity, usually 5 or 10 years, the balloon that had to be repaid was equal to the original loan amount.
Payments on balloon loans offered today in the US and Canada are calculated on a 30year amortization schedule, so there is some principal reduction. Assuming a rate of 6.5%, for example, a $100,000 loan would have a balance remaining at the end of the fifth year of $93,611.
Maturities on balloons in the US are almost all 5 or 7 years, but balloons are much less common than indexed ARMs. In Canada, where balloons are the standard mortgage, maturities range more widely.
Advantages and Disadvantages: The table below summarizes the advantages and disadvantages of balloon mortgages, to borrowers and lenders, relative to indexed ARMs with an initial rate period equal to the maturity of the balloon.

Borrowers 
Lenders 
Advantages Relative to Indexed ARMs 
Simpler and easier to understand, easier to shop. Lower interest rate. 
Makes management of interest rate risk easier by removing contractual constraints. 
Disadvantages Relative to Indexed ARMs 
No protection against a rise in rates at maturity. Changing lenders at maturity imposes refinance costs. Lenders obligation to refinance at maturity may be ambiguous. 
Lower interest rate. 
Flexible maturity ARMs (FMAs) are a special type of indexed ARM. Their distinguishing feature is that changes in the interest rate result in changes in the maturity rather than the payment. Borrowers know in advance what their payment will be, but they don’t know how long they will have to pay. If rates go up, they pay for a longer period, up to some maximum, and if rates go down they pay off more quickly.
For example, the initial term might be 15 years and the maximum 40 years. There is no minimum period.
The initial term used to calculate the payment must be significantly shorter than the maximum in order to provide scope for rate increases. If the initial term is 30 years and the initial rate is 6%, extending the term to 40 years will offset an immediate rate increase only to 6.70%. This is not sufficient protection for lenders.
To be attractive to lenders, the initial term on an FMA must not exceed 15 years. A term extension from 15 to 40 years would offset an immediate rate increase from 6% to 9.93%. If the increase was delayed for 3 years, the new rate could be as high as 11.65%. The longer a rate increase is delayed, the larger the increase that can be offset by an extension of the maturity.
Because the payment at 15 years is larger than most borrowers can afford, FMAs offered in the US have never been very popular. An obvious remedy is to graduate the payment in the same way as on a graduated payment mortgage (GPM). For example, the payment could increase by 7.5% a year for 5 years, before leveling off. Then lenders would have the rate protection provided by the short initial term, and borrowers would have a more affordable initial payment. To my knowledge, however, no lender has ever offered this instrument.
Advantages and Disadvantages: The tables below summarize the advantages and disadvantages of FMAs relative to standard indexed ARMs.

Borrowers 
Lenders 
Advantages Relative to Indexed ARMs 
Future payments are known in advance. 
Rate increases do not cause payment problems for borrowers resulting in defaults. 
Disadvantages Relative to Indexed ARMs 
Initial payment is higher. Payoff period is uncertain. 
Loan duration is not known in advance. 
The dual index mortgage (DIM) is one of several types designed to function in an inflationary economy. The distinguishing feature of DIMs is that the rate is indexed to a market interest rate, while the payment is indexed to a wage and salary index. Since the indexes are independent of each other, there is no builtin mechanism that assures that the loan will amortize over its term.
From a lender perspective, the DIM looks much like any other indexed mortgage. The lender earns a rate equal to a rate index plus a contractual margin that is fixed for the life of the loan. From the standpoint of the borrower, however, the DIM is nothing like an indexed ARM.
The initial payment on the DIM is relatively low, consistent with what the borrower can afford.For example, at a time when the interest rate is 35%, the rate used to calculate the initial payment might be 15%. This would result in negative amortization for a period. As the payment increases based on changes in the wage and salary index, negative amortization will decline, then become positive amortization, and finally become fully amortizing.
There is no assurance, however, that the loan balance will be fully paid off by the maturity date. Given the inflation rate, whether the DIM amortizes fully or not depends on: a) The term; b) The lenders’ margin over the rate index; c) The increase in the wage and salary index; and d) The payment rate used to calculate the initial payment.
A convenient way to view these relationships is to show the lowest initial payment rate that will result in full amortization at various values of the other variables. See the table below.
Option ARMs are a special type of indexed ARM. Their distinguishing feature is that borrowers have options on how large a payment they will make in the early years. The options include making fully amortizing payments on 15year or 30year schedules, paying interest only, and making a “minimum” payment that is less than interest only, which results in negative amortization.
Marketing Option ARMs: The main selling point of option ARMs is the low minimum payment option, which most borrowers select. The minimum payment in year 1 is calculated at the interest rate in month 1, which can be as low as 1%, The payment rises by only 7.5% a year for 5 or 10 years. The low initial payment entices some borrowers into buying more costly houses than they would have otherwise, or tempts them to use the monthly payment savings for other purposes.
The Risks of an Option ARM: For those electing the minimumpayment option, the major risk is “payment shock”—a sudden and sharp increase in the payment for which they are not prepared. The rule that the minimum payment can rise by no more than 7.5% a year has two exceptions. The first is that every 5 or 10 years the payment must be “recast” to become fully amortizing. It is raised to the amount that will pay off the loan within the remaining term at the then current interest rate—regardless of how large an increase in payment is required. The second exception is that the loan balance cannot exceed a negative amortization maximum, which can range from 110 to 125% of the original loan balance. If the balance hits the negative amortization maximum, which can happen before 5 years have elapsed if interest rates have gone up, the payment is immediately raised to the fully amortizing level. Either the recast provision or the negative amortization cap can result in serious payment shock.
Borrower Protection Against Payment Shock: There are three things borrowers can do to minimize the possibility of payment shock.
Who Should Take an Option ARM? It may make sense forborrowers who want to maximize their homebuying capacity, and either have a short time horizon, or confidently expect their income to rise in the future. As a refinance option, it makes sense only for borrowers whose incomes have fallen and who will be forced to default unless they can reduce their payment. I usually advise against using this instrument to generate cash flow savings to invest because few people have access to safe investments that yield more than the cost of an option ARM.
Shopping for Option ARMs Is Relatively Simple: Because the initial interest rate holds only for one month, lenders don’t reprice them every day as they do other indexed mortgages, which makes comparison shopping much easier. Borrowers can shop the margin, which determines the rate after the first month.
Option ARMs During the Housing Bubble and the Crisis That Followed: Option ARMs were a favorite instrument of speculators in the US during the housing bubble of 2002–2007, and their volume ballooned. When house prices began to decline in 2007, however, the combination of rising payments and negative equity caused a precipitous rise in defaults. In 2008 and 2009, no new option ARMs were written.
Advantages and Disadvantages: The tables below summarize the advantages and disadvantages of option ARMs relative to standard indexed ARMs. as alternative ways of reducing payments in the early years.

Borrowers 
Lenders 
Advantages Relative to Standard Indexed ARMs 
Initial payment is lower, perhaps much lower. Easier to shop. 
Monthly rate adjustments makes management of interest rate risk easier. 
Disadvantages Relative to Standard Indexed ARMs 
Vulnerable to severe payment shock. 
Default rates are higher because of potentially large payment increases. 