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Are there different types of mortgages?
Yes. The two basic types of mortgages are fixed rate and adjustable rate.
Fixed Rate Mortgages
If you’re looking for a mortgage with payments that will remain essentially unchanged
over its term, or if you plan to stay in your new home for a long period of time,
a fixed rate mortgage is probably right for you.
With a fixed rate mortgage the interest rate you close with won’t change—and
your payments of principal and interest remain the same each month—until the mortgage
is paid off.
The fixed rate mortgage is an extremely stable choice. You are protected from
rising interest rates and it makes budgeting for the future very easy.
But in certain types of economies, the interest rate for a fixed rate mortgage
is considerably higher than the initial interest rate of other mortgage options.
That is the one disadvantage of a fixed rate mortgage. Once your rate is set,
it does not change and falling interest rates will not affect what you pay.
Fixed rate mortgages are available with terms of 15 to 30 years with the 15-year
term becoming more and more popular. The advantage of a 15-year over a 30-year
mortgage is that while your payments are higher, your principal will be paid off
sooner, saving you money in interest payments. Also, the rates may be lower with
a 15-year loan.
Adjustable Rate Mortgages (ARMs)
An adjustable rate mortgage is considerably different from a fixed rate mortgage.
ARMs have only been around since the early 1980s. They were created to provide
affordable mortgage financing in a changing economic environment.
An ARM is a mortgage where the interest rate changes at preset intervals, according
to rising and falling interest rates and the economy in general. In most cases,
the initial interest rate of an ARM is lower than a fixed rate mortgage. However,
the interest rate on an ARM is based on a specific index (such as U.S. Treasury
Securities). This index reflects the level of interest rates and allows the lender
to match the income from your ARM payment against their costs. It is often selected
because it is a reliable, familiar financial indicator. Monthly payments are adjusted
up or down in relation to the index.
Most ARMs have caps—limits the lender puts on the amount that the interest rate
or payment may change at each adjustment, as well as during the life of the mortgage.
With an ARM, you typically have the benefit of lower initial rates for the first
year of the loan. Plus, if interest rates drop and you want to take advantage
of a lower rate, you may not have to refinance as you would with a fixed rate
mortgage. An ARM may be especially advantageous if you plan to move after a short
period of time.
The convertible ARM is an option that is currently very popular because it allows
you to convert to a fixed rate mortgage after a specified period of time has elapsed.
For instance, you could get a one-year ARM with the option to convert to the prevailing
fixed interest rate at any time after the first through the fifth adjustment period.
Convertible ARMs offer the ability to take advantage of lower rates initially
and have possible savings, and the option to convert to a fixed rate loan later
on when you may be able to better afford it. Depending on your financial needs,
you might find this option the best of both worlds.
As a relatively new phenomena, the purpose of an ARM is often misunderstood.
Ask your mortgage lender to explain the details to you so you can determine if
this type of mortgage fits your specific financial situation.
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