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Fixed or Adjustable?
One of your first decisions should be between a fixed rate (the interest rate and monthly payment remains constant for life of the mortgage) or an adjustable rate (the interest rate is adjusted -- either up or down -- at specified times during the mortgage term).
Adjustable Rate Mortgages (ARMs) start with a lower rate than fixed loans, but are subject to fluctuation after a specified period. They may be a good choice if you are fairly sure that you will not be owning the home for an extended period of time (more than five to seven years). However, you need to be sure that the adjustable rate is low enough to justify the risk that you will be in the home longer than you had planned.
Advantages of a Fixed Rate Mortgage
Easier to budget, since your payment is always the same.
No possibility of an interest rate change making your mortgage payment suddenly unaffordable.
No anxiety over interest rate fluctuations.
Disadvantages of a Fixed Rate Mortgage
More income needed to qualify because of higher initial mortgage rate.
If interest rates go down in the future, you will need to refinance to get a lower payment.
Fixed rate loans are not assumable by a new buyer of your home.
If you make extra principal payments, you will shorten the life of your loan, and save on interest, but your monthly payment will not decrease.
Difference between a 15 and 30 Year Amortization
The monthly payment will be higher for a 15 year loan, but the interest rate is usually lower, and your savings over time are enormous. That is, you will save thousands of dollars in interest payments if you pay your loan in 15 rather than 30 years. For example, let’s compare a $250,000 mortgage at 6.5% over a 15 year term and a 30 year term:
15 year 30 year
$2178 $1580
Total Interest $193,133 $442,022
TIP: If you can't qualify for a 15 or 20 year loan, try to pay at least the equivalent of one additional payment per year -- this will knock nearly 10 years off a 30 year loan!
Learn about the types of fixed rate loans.
Adjustable Rate Mortgages (ARMs)
Advantages of an ARM
Lower initial monthly payments so you can "grow into" your mortgage.
You will qualify for a larger mortgage, thus a higher purchase price.
Most ARMs can be assumed by a new buyer when you sell your home.
If interest rates decline, your payment will also decline.
If you make extra principal payments during the fixed period, your payments may actually decrease at the next rate adjustment.
Disadvantages of an ARM
If the loan index goes up, your payments will also go up.
A large increase in the loan index could make the payments unaffordable.
You might spend a lot of time worrying about upcoming rate increases.
With some ARMs, your interest rate may increase 4 to 5% at the first adjustment – although most are capped thereafter at 2% per year.
THE TWO MAJOR TYPES OF ARMs
Hybrid ARM's incorporate a fixed-rate feature, i.e., the initial rate is fixed for a period of time, and then the loan becomes adjustable.
Option ARM's. These are based on either the COFI index or the MTA index, and you will be given the option to defer part of the interest each month. "Deferred" interest will be paid later, when you sell the home or refinance, and until that deferred interest is paid, your loan is not being paid off according to a normal amortization schedule, but is "negatively amortizing".
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