Purchasing a home is one of the most important decisions of your life. It affects everything, from schools to finances to relationships As a consumer you have several different options and it is imperative that you make the right choice for you and your situation….
What is a Mortgage?
Before we get into the main types of mortgages, lets clarify what a mortgage is… A mortgage is a loan that’s used to buy real estate that compensates the difference between how much money you have to put down and what the home costs.
For example: If the house costs $250,000 and you have $25,000 to put towards the down payment, your mortgage is $225,000.
There Are Two Main Types Of Mortgage Loans…
The first main type of mortgage is called a fixed-rate mortgage. It’s exactly what it sounds like… It’s a loan with an interest rate that’s fixed and never changes. It doesn’t matter what happens to the the world around you, 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, 10, 20, 40, and even 50-year terms are available.
Here is a quick glimpse of the going rates:
|Conforming and Government Loans|
|30-Year Fixed Rate||3.750%||3.810%|
|30-Year Fixed-Rate FHA||3.750%||4.758%|
|30-Year Fixed-Rate VA||3.375%||3.662%|
|15-Year Fixed Rate||3.000%||3.105%|
|5/1 ARM VA||3.000%||2.874%|
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. 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 mortgages because they reduce the monthly payment, which can make buying a home more affordable.
The Second main type is an 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 down on a predetermined basis that’s usually subject to an index like the T-bill rate or the LIBOR.
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.
A 5/1 ARM loan has a fixed interest rate for the first 5 years. After 5 years, the rate can change once every year for the remaining life of the adjustable-rate mortgage. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.
A 7/1 ARM loan has a fixed interest rate for the first 7 years. After 7 years, the rate can change once every year for the remaining life of the adjustable-rate mortgage. When the rate changes, your monthly payments will increase if rates go up and decrease if rates fall.
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.
Different Types of Adjustable-Rate Mortgages
There are also 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?
Now that you understand the major differences between fixed and adjustable-rate mortgages, let’s look at when and why 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 are going to sell or refinance. Getting rid of an ARM during an initial fixed-rate period 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.
I hope that this article was helpful. If you would like more information on how to figure out what type of loan would be best for you, simply fill out the form below and we will be in touch!