The two main types of mortgages are fixed-rate mortgages and adjustable-rate mortgages (ARMs). Although the market offers a variety of mortgages within these two broad categories, you must first determine which of the two mortgage types best fits your needs.
Years ago, only one kind of mortgage was commonly available to prospective home buyers: a fixed-rate mortgage. With a fixed-rate mortgage, the interest rate you pay remains constant for the duration of the loan. So if you have a 30-year mortgage loan for $300,000 — with an interest rate of 7 percent — you’ll pay the same 7-percent rate with your last payment as you did with your first.
Is a fixed-rate mortgage in your future? Time to take a closer look and see.
Understanding common fixed-rate mortgage loans
In many ways, fixed-rate mortgages are boring. They’re plain (not a lot of complex terms and conditions), predictable (the rate never changes), and sturdy (they’re built to hold up for the long haul). Of course, these very features also make fixed-rate loans attractive to so many potential home buyers.
Two major kinds of fixed-rate mortgages are available today:
- 30-year: This fixed-rate mortgage is amortized (that is, the total cost of the loan — principal, and interest — is spread out) over a 30-year period of time.
- 15-year: This fixed-rate mortgage is amortized over a 15-year period of time — exactly half the time of a 30-year loan. Because of the significantly shorter loan term, monthly payment for a 15-year fixed-rate mortgage is generally higher than for a comparable 30-year fixed-rate loan, although you actually pay far less interest over the life of a 15-year loan than you do with a 30-year loan. Additionally, the interest rate lenders offer is often lower than for a 30-year fixed-rate loan.
Other fixed-rate mortgages are available — you may find 10-, 20-, and even 40-year loans if you look really hard — but they are relatively uncommon. For most people, the good old-fashioned but reliable 30-year fixed-rate mortgage is just right for the job.
Fixed-rate Mortgages Pros
Fixed-rate loans offer a number of advantages over other mortgage loan alternatives. These plusses are a few of the most notable:
- Because a fixed-rate loan doesn’t change over the entire loan term, you always know exactly what your monthly house payment will be — yesterday, today, and tomorrow. Your long-term financial planning is thus much more accurate.
- You are protected against inflation because, as prices rise on other things you may buy during the coming years, your house payment remains the same. In other words, your home becomes more affordable over time (assuming your income increases).
- Because your payment is fixed and predictable, your financial risk is less than for nonfixed-rate loans, which may change at virtually a moment’s notice.
Fixed-rate Mortgages Cons
If the news about fixed-rate mortgages was all good, no other options would be available. But, of course, plenty of other options abound. Here are some of the cons about fixed-rate mortgages:
- The interest rate on a new fixed-rate loan is usually higher than the interest rate on an adjustable-rate loan. If the interest rate on your fixed-rate loan is high, you may pay more money over the life of the loan than for an adjustable-rate loan.
- Because the interest rate for a fixed-rate loan is usually higher than for alternative loan vehicles, it may be harder to qualify for a fixed-rate loan based on your income and other financial considerations.
- If market rates fall below the rate you are paying with your fixed-rate loan, you will be paying more for your home than someone entering into a comparable loan agreement.
Even if you find yourself in a bad fixed-rate mortgage — meaning you are paying an interest rate that is significantly higher than the current prevailing rate for a comparable loan — you’ve always got the option of refinancing your loan. Thus, you can take out a new mortgage loan that pays off your old loan and restarts the mortgage clock — this time with a better interest rate and probably a lower monthly payment.
During the early 1980s, interest rates for home mortgages went through the roof. At the time, fixed-rate mortgages of 13, 14, and 15 percent weren’t just common — they were the norm. Many prospective home buyers simply didn’t have enough income to qualify for fixed-rate loans at these rates, despite the fact that home prices were considerably less than they are today.
As you learned in high school physics, nature abhors a vacuum. In response to this need for affordable mortgage loans, the industry invented the adjustable-rate mortgage (ARM) loan.
Also known as a variable-rate loan, adjustable-rate mortgages start out at a relatively low rate — sometimes several points or more below a comparable fixed-rate loan — and then adjust up or down on a periodic basis. If everything sounds a bit complicated, that’s because it is. The next sections take a closer look at adjustable-rate loans.
Understanding common adjustable-rate mortgage loans
A number of different adjustable-rate mortgage loans are available to prospective home buyers. The terms and conditions vary from loan to loan, but you can keep a few basics in mind as you shop around. Be sure to pay close attention — the devil in the details of adjustable-rate mortgages often trips people up.
Initial interest rate: Every adjustable-rate loan has to start somewhere, and this somewhere is the initial interest rate — the rate you pay until your first loan rate adjustment. This rate, which may be discounted as an inducement to get you to sign on the dotted line, could last anywhere from one month to ten years.
Adjustment period: After your initial interest rate expires, your ARM will adjust on a regular schedule called the adjustment period. At the end of the adjustment period, the rate is reset and the monthly loan payment is recalculated. The adjustment period may last anywhere from one month to five years.
Index rate: Adjustable-rate mortgage interest rate changes are usually linked to changes in a specific index rate. The most common indexes include the rates on one-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). In some cases, lenders use their own cost of funds as an index.
Margin: Most lenders add a few extra percentage points to the index rate to determine the actual interest rate that will be used when the ARM adjusts. The index rate plus the margin is called the fully indexed rate — the rate you pay. For example, if the index rate is 4 percent and the margin is 2.5 percent, the fully indexed rate is 6.5 percent.
Interest rate caps: What keeps your ARM from completely going nuts and your interest rate from blasting into the stratosphere? Interest rate caps do the trick. A periodic adjustment cap is a limit on the maximum interest rate increase that can be charged at the end of each adjustment period, perhaps half a percentage point. A lifetime cap is the maximum interest rate that can be charged over the life of the loan, such as 12 percent.
As we mentioned earlier, many different kinds of adjustable-rate mortgage loans are available. Here are a few of the most common:
Hybrid ARM: This kind of mortgage is a mix of fixed-rate and adjustable-rate loans. Generally, a hybrid ARM starts with an introductory interest rate that is fixed for a period of time — commonly three, five, seven, or even ten years — and then converts to an adjustable loan after the introductory period expires. In the case of a 3/1 hybrid ARM, the introductory interest rate is fixed for three years and, after the three-year period expires, adjusts annually. In the case of a 5/1 hybrid ARM, the introductory rate is fixed for five years, after which the loan adjusts annually.
Interest-only ARM: This mortgage loan is like a hybrid ARM, except that you only pay interest and not principal. Although this ARM makes qualifying much easier for many individuals, if the interest rate increases, the monthly payment can also increase, causing these same individuals to have problems coming up with the additional money necessary to keep their mortgages well-fed and happy. Not only that but because you’re not paying any money toward the principal, you’ll be stuck owing the entire loan amount when the mortgage term ends.
Payment-option ARM: This unique adjustable-rate mortgage allows you to decide each month what kind of payment you want to make. The choices commonly include these:
- Making an interest-only payment.
- Making a standard payment of principal and interest.
- Making a minimum payment, much like the minimum payment on a credit card, that keeps your account current but that does not reduce your principal and interest owed. In fact, making only the minimum payment often causes negative amortization, a situation in which the amount you owe on your loan actually increases over time rather than decreases.
Adjustable-rate Mortgage Pros
Despite the black eye that adjustable-rate mortgages have received lately, they offer advantages to people who select them:
- Because the initial interest rate on an adjustable-rate loan is often significantly less than for a comparable fixed-rate loan, a home buyer may save a significant amount of money — particularly in the first years of the loan.
- Adjustable-rate loans are often easier for homebuyers to qualify for than fixed-rate loans.
- A lot of different adjustable-rate mortgage programs are available — you’ll surely find the right one for you.
- Adjustable-rate loans can be good if you plan to keep your property for only a few years before you sell it.
- When interest rates are declining, an adjustable-rate loan gives you a distinct advantage over borrowers who are stuck in higher-interest fixed-rate mortgages.
Adjustable-rate Mortgages Cons
In case you haven’t read a newspaper lately, most of the bad news about home loans involves adjustable-rate loans with increasing interest rates that are difficult for homeowners to keep up with. Yes, Virginia, there’s no small amount of bad news about adjustable-rate mortgages. Here are some of the worst:
- Although adjustable-rate mortgages generally start at a lower interest rate than fixed-rate mortgages, this situation may not last forever. Many such loans experience their first (usually upward) adjustment just a year after loan inception, with subsequent adjustments on a quarterly or semiannual basis.
- Most adjustable-rate mortgages have a maximum interest rate cap, but the maximum rate is often far above what home buyers with fixed-rate mortgages will experience.
- In a worst-case scenario, if you make only the minimum payment your loan may negatively amortize — that is, your loan principal can grow instead of shrink as you make payments. Long story short, you can end up with a loan in a larger amount than you originally signed up for — definitely bad news.
- This kind of loan is unpredictable, making long-term financial planning difficult, if not impossible.
Deciding What Loan Is Best for You
Ultimately, you need to wade through all the different mortgage loan options available and decide which is best for you.
The material in this article should help you make a decision, but you need to take a close look at your unique financial situation and take that into account. If you’re unsure which way to go, don’t hesitate to consult your real estate agent, CPA, mortgage loan broker, or real estate attorney.
One of the best ways to help make the right decision for you is to compare the different costs of each kind of loan. Consider the following example that shows the impact of a number of common mortgage loans for a $200,000 home with a 10-percent ($20,000) down payment:
Traditional fixed-rate mortgage
30-year term; 6.7-percent interest rate
Loan balance after five years: $168,882
Equity after five years: $31,118 ($20,000 down payment plus $11,118 principal paid on mortgage)
Traditional 5/1 ARM
30-year term; 6.4 percent for first 5 years
Loan balance after five years: $168,305
Equity after five years: $31,695 ($20,000 down payment plus $11,695 paid on mortgage)
5/1 interest-only ARM
30-year term; 5 years of interest-only payments, and then 25 years of principal and interest payments; 6.4-percent interest rate for first 5 years
Loan balance after five years: $180,000
Equity after five years: $20,000 ($20,000 down payment)
Payment-option ARM (Example 1)
30-year term; 5 years of minimum payments, and then recast for remaining term; starting interest rate of 1.6 percent for 1 month, then 6.4 percent; assume no rate increases
Loan balance after five years: $195,562
Equity after five years: $4,438 ($20,000 down payment minus $15,562 negative equity)
Payment-option ARM (Example 2)
30-year term; 5 years of minimum payments allowed, and then recast for remaining term; starting interest rate of 1.6 percent, and then 6.4 percent; 7.5-percent annual payment cap; assume rate increases 2 percent per year up to 12.4 percent. This loan will reach the 125-percent balance limit in month 49 and will be recast as an amortizing loan at the beginning of year 5.
Loan balance after five years: $223,432
Equity after five years: –$22,432 ($20,000 down payment minus $42,432 in negative equity)
As you can see, the good-old boring but reliable traditional fixed-rate mortgage is virtually tied with the 5/1 ARM in offering both the smallest loan balance after five years and the greatest growth in equity.
What we don’t know from this example, however, is what happens after five years. If interest rates climb, the fixed-rate loan was the better choice. If interest rates fall, the adjustable-rate loan was the better choice.
The payment-option ARMs do worst in this scenario, with the final example showing how such a loan can leave you owing more after five years than when you started. Combined with falling housing prices, this situation can be a recipe for financial disaster — one well worth avoiding.
Careful selection, no matter what type of loan you choose, will help you avoid costly mistakes. One thing you should know: Do not take out an ARM because you think the monthly payment will be lower. With a fresh start, you may get a similar interest rate, but you are gambling a bit. In the long run, it’s better to look for a home with a lower rate.