Mortgage Types: Differences between Fixed Rate and Adjustable Rate Mortgages
Before choosing a mortgage, you need to understand the differences between mortgage types: fixed rate mortgages, adjustable rate mortgages, and interest-only mortgages, to name a few. Read our related article on buying a house using the lease option.
Fixed Rate Mortgages
With a fixed-rate mortgage, the interest rate and the amount you pay each month remain the same over the entire mortgage term, traditionally 15 to 30 years. You can use this fixed rate mortgage calculator to figure out your payment. Lenders may also offer variations on fixed rate mortgages, including five- and seven-year fixed rate loans with balloon payments at the end.
Adjustable Rate Mortgages (ARMs)
With an adjustable rate mortgage (ARM), the interest rate fluctuates according to the interest rates in the economy. Initial interest rates of ARMs typically are offered at a discounted (“teaser”) rate that’s lower than the rate for fixed rate mortgages. Over time, when initial discounts are filtered out, ARM rates will fluctuate as general interest rates go up and down.
Different ARMs tied to various financial indexes are some of which fluctuate up or down more quickly than others. To avoid constant and drastic changes, ARMs typically regulate (cap) how much and how often the interest rate and payments can change in a year and over the life of the loan.
Over the years, some variations have been made available for adjustable rate mortgages. Including hybrids that change from a fixed to an adjustable rate after a period of years, or “option ARMs” that allow you to choose, on a monthly basis, whether to pay a minimum amount, an interest-only amount, an ordinary principal plus interest amount, or an accelerated payment amount. However, with the recent credit crisis, many of these variants have disappeared — especially for the very people who desire them most, those with low income and assets.
During the real estate boom years of the late 1990s and early 2000s, “interest-only” loans became a popular option. These allowed the borrower to pay only the interest amount each month — not any principal — for the first several years of the loan. The advantage, of course, was that these loans lowered the home buyer’s initial monthly payments significantly, allowing someone to afford more house. But a lot of people got themselves into trouble with these loans. Eventually, the borrower must pay off the loan balance. The shift in monthly payments can be a shocker — and refinancing becomes impossible if the house has gone down in value such that it’s worth less than the amount owed on it. Interest-only loans are virtually unavailable now, and you’d be wise to avoid them anyway.
How to Choose the Best Mortgage Type
Because interest rates and mortgage types change often, your choice of mortgage type should depend on:
- the interest rates and mortgage types available when you’re buying a house
- your view of the future (generally, high inflation will mean ARM rates will go up and lower inflation means that they will fall)
- your personal financial and investment goals, and
- how willing you are to take a risk.
When mortgage rates are low, a fixed rate mortgage is the best bet for many buyers. Over the next five, ten, or 30 years, interest rates are more apt to go up than further down. Even if rates could go a little lower in the short run, an ARMs teaser rate will adjust up soon, and you won’t gain much if you plan to stay in the house more than a few years (the broker can tell you your break-even point). In the long run, ARMs are likely to go up, meaning many buyers will be best off locking in a favourable fixed rate now and not taking the risk of much higher rates later.
There are mortgage types comparison calculators that allow you to enter the terms (rates, points, closing fees) of up to three different mortgages to compare their value (total payments, taxes saved, and present value). See our article on how to qualify for a mortgage.
When making a choice between types of loans, always keep in mind that you may not keep it for its full term. For example, if you take out a fixed rate loan now, and several years from now interest rates have dropped, refinancing may be an option (assuming your house hasn’t declined in value, in which case the lender won’t accept it as collateral for the refinanced loan).
There are several downsides to refinancing, however. For one, if you default on a refinanced mortgage, your position under your state’s law might worsen. In some instances, when a home buyer defaults on a new home loan (stops paying the mortgage), the lender can foreclose on the house. However, take nothing else from the home buyer, while on a refinanced mortgage the lender can go after the home buyer’s cash and other assets, after the house, to satisfy the debt.
Also, unless you can negotiate a low-cost refinance, you may have to pay the same fees and points as for an original mortgage, i.e., you may reduce your monthly payment right away but not begin to save money on the refinance for several years.
Another issue is that by refinancing, you stretch your mortgage term back out to another 30 years (or whatever the new loan’s term). That looks like a good deal in the short term, as your monthly payments go down. But it’s an artificial saving, given that the amount of interest you end up paying overall to buy your home can go way up this way. Compare your total interest payments to see the effect. Then seriously consider adding to your monthly payments to stick to your original end date, which should cure this issue.