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.