What Is the Best Type of Mortgage?
Find out whether a fixed or adjustable mortgage is right for you.
When you buy a home, getting a loan can be really confusing because there are so many different mortgage products that lenders offer. But the truth about mortgages is that there are really just two main types. Once you understand how they work, you’ll know which one is the best type of mortgage for you.
What is a Mortgage?
Before we get into the two main types of mortgages, I should probably make sure that you know what a mortgage is. A mortgage is a loan that’s used to buy real estate that closes the gap between the purchase price and how much money you have for a down payment. For instance, if you agree to pay $200,000 for a home but only have $20,000 to put down, then you need a mortgage for the difference, or $180,000 ($200,000 - $20,000).
What is a Fixed-Rate Mortgage?
The first main type of mortgage is called a fixed-rate mortgage. It’s exactly what it sounds like, a loan with an interest rate that’s fixed and never changes. It doesn’t matter what happens to the economy, the stock market, or inflation, the rate you agree to is locked in for the entire life of the loan. The most common fixed-rate mortgage terms are 15-and 30-years. However, you’ll also find 10-, 20-, 40-, and even 50-year fixed-rate mortgages!
A benefit to getting a shorter mortgage is that you pay it off faster, of course, but also that it comes with a lower interest rate than a longer-term mortgage. For example, right now the going rate for a 15-year fixed is 4.15% and a 30-year fixed is 4.89%. And along with paying the mortgage off faster, you pay much less total interest over the life of the loan with a shorter-term mortgage than with a longer one. But many people go for longer mortgagesbecause they reduce the monthly payment, which can make buying a home more affordable.
What is an Adjustable-Rate Mortgage (ARM)?
Okay, let’s talk about the second main type of mortgage, which is the adjustable-rate mortgage or ARM. You might also hear it referred to as a variable-rate mortgage.With adjustable mortgages the interest rate and your monthly payment can go up or downon a predetermined basis that’s usually subject to an index like the T-bill rate or the LIBOR.
Since adjustable mortgages are more unpredictable and risky than fixed-rate mortgages, they offer a much lower interest rate—at least in the beginning. I told you that the going rate for a 30-year fixed mortgage is 4.89%. Compare that to a 30-year 5/1 ARM, which is just 3.48%. If you’re wondering what the heck a 5/1 ARM is, let me explain.
Most ARMs are actually a hybrid loan that’s both fixed and adjustable. They start off with a fixed-rate and then convert to an adjustable rate. So the first number on an ARM is how many years are fixed and the second number is how often the rate will change after the fixed period ends. For instance, a 5/1 ARM gives you five years with a fixed rate and then can adjust, or reset, every year going forward starting in the sixth year. A 3/1 ARM has a fixed rate for three years with a potential rate adjustment every year after that.
Different Types of Adjustable-Rate Mortgages
In addition to hybrids, there are other types of adjustable-rate mortgages, like interest-only and payment-option ARMs:
Interest-only ARM: Allows you to pay just interest for a certain number of years, which makes your monthly payment much smaller during that period, but doesn’t reduce the size of your debt. For example, if you get a 30-year mortgage with a 5-year interest-only period, you can pay just interest for five years and then make higher payments that include both principal and interest for the remaining 25 years of the loan.
Payment-option ARM: Allows you to choose from several payment options each month, such as interest-only, principal and interest, or making a minimum payment that’s less than the interest due.
How Much Can an Adjustable-Rate Mortgage Increase?
You might be wondering how much an adjustable-rate loan can increase. I’ve had several adjustable-rate mortgages and it can be a little unnerving knowing that the payment could increase. But it’s also pretty exciting when the payment goes down! ARMs come with built in caps or limits on how much the interest rate can climb from one adjustment period to the next and how high it can go over the entire term of the loan. So you always know the worst-case scenario.
When Should You Get a Fixed-Rate Mortgage?
[[AdMiddle]Now that you understand the major differences between fixed and adjustable-rate mortgages, let’s discuss when they make sense. Here are three situations where you might want to go for a fixed-rate mortgage:
Interest rates are rising. Locking in a low interest rate for the life of your home loan is a fantastic way to protect yourself against inflation.
You want stability. Having the exact same mortgage payment for decades ensures that you’ll never have any financial surprises.
You’re not going to move. Over the long-term a fixed-rate mortgage could potentially save you the most interest, especially if interest rates go up.
When Should You Get an Adjustable-Rate Mortgage?
Here are five situations when it makes sense to consider getting an adjustable-rate mortgage:
Interest rates are steady or declining.When rates don’t go up, you can expect to have a steady or lower monthly payment.
Your income is rising. If you’re confident that you’ll earn enough to cover the worst-case scenario for adjustable-rate payment increases.
You need a low interest rate to qualify. A low introductory rate means that you usually qualify to borrow more money than with a higher-rate, fixed loan.
You want to save interest. A low introductory rate means you save a lot of interest in the first few years of ownership.
You’ll probably sell or refinance. Getting rid of an ARM during an initial fixed-rateperiod doesn’t put you at risk if interest rates rise.
How to Choose an Adjustable-Rate Mortgage
Under the right circumstances an adjustable-rate mortgage can save you interest and keep your payments as low as possible. That can free up more of your money for savings and investments. However, an ARM can also lead to big financial problems if you don’t really understand how it works. Many foreclosures were the result of borrowers who mistakenly thought they could afford expensive homes because the initial interest rates were low. As the rates adjusted up they couldn’t afford the increased payments and were stuck with the loan because they couldn’t qualify for a refinance or sell the property.
If you’re considering an ARM, make sure to carefully review the loan’s Good Faith Estimate that tells you how your rate is determined, how often the rate could change, and how much your payments could rise. Ask the lender lots of questions including specific examples about how high your payments could go. If you’re going to stay in the home for a long time, be absolutely sure that you can afford the worst-case scenario for interest rate increases on an adjustable-rate mortgage. If you can’t, it’s smart to buy a less expensive home or to get a fixed-rate mortgage.
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If you like these tips about mortgages, I think you’ll like my book, Money Girl’s Smart Moves to Grow Rich. You can download two free chapters at SmartMovesToGrowRich.com! Chapter 8 is all about buying real estate. You’ll find out whether you should buy or rent, how much house you can afford, how to find the best mortgage, how to take advantage of the mortgage interest deduction, and lots more. The paperback is available at Amazon.com or your favorite book store and as an e-book for your Kindle, Nook, iPad, PC, Mac, or smart phone.
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