One characteristic of the two most common type of mortgages is that their names tell you how they work. For example:
1. A fixed rate mortgage carries a specified interest rate that is fixed and cannot change during the term of the mortgage. They are commonly available in 15- and 30-year terms.
2. An adjustable rate mortgage or ARM, on the other hand, allows the lender to adjust the interest rate during the life of the loan. During the initial loan term, most commonly 3-10 years, the initial interest rate cannot change. Future changes are determined by applying a margin to an interest index rate. If your mortgage interest rate goes up or down, it’s reflecting current rate changes in the market at the time of the change. A cap generally limits periodic interest rate changes and represents the highest amount a mortgage rate can change over a certain period. A lifetime cap, which is the highest amount of change that can occur during the term or lifetime of the mortgage, is another way rates are kept within a certain range.
Once you understand these two types of mortgages, you can decide which product is right for you. Here are some of the advantages and disadvantages:
- A fixed rate mortgage is a good choice if you want predictable monthly principal and interest payments for the life of the loan, if you expect to live in a home for an extended period, or if you want to lock in low interest rates. If interest rates drop lower, you can always refinance the loan, although there will be a cost.
- Fixed rate mortgages let you budget payments more easily. You don’t have to worry about being unable to afford the mortgage because there are no sudden rate changes.
- On the downside, with a fixed rate mortgage, you need to show more income to qualify because of the higher initial interest rate.
- An adjustable rate mortgage is a good choice if you plan on living in your home for a short time or if you plan to pay down your mortgage faster than a fixed rate loan. The initial interest rate on an ARM is generally lower than that of a fixed-rate mortgage, which means lower monthly payments. Plus, if interest rates continue to drop, so does your monthly payment.
- If rates rise and you have an adjustable rate mortgage, however, you will need to dedicate a bigger portion of your monthly budget to your mortgage payment. If the payment becomes too large, you may no longer be able to afford your mortgage.
Here are four questions that can help you decide which mortgage product is right for you:
| Question | Yes | No |
| 1. Is your income likely to increase enough to cover higher mortgage payments if interest rates go up? If you answer “Yes,” either an adjustable rate or a fixed rate mortgage would work for you. | ||
| 2. Will you have other substantial debts, such as car loans or school tuition, in the near future? If “Yes,” a fixed rate mortgage might be better for you. | ||
| 3. Can you handle increased payments? If “No,” a fixed rate mortgage would be better suited to your situation. | ||
| 4. Do you plan to own the home for less than three years? If you answer “Yes,” an adjustable rate mortgage might be more beneficial. |
Answer the questions honestly and you’ll have a realistic picture of your financial situation and a solid understanding of whether you could comfortably afford to take on increased interest rates.
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