Deciding to purchase a home is one of the largest decisions most people will make in their lifetime. It is also one of the most expensive purchases a person will make. While a lot of people think that buying a home is all fun and excitement and a time filled with lists of must haves and home tours the reality is that it’s a much more complicated process. The most important and difficult part of buying a home is trying to determine which type of mortgage will work for you.
All mortgages have their own pros and cons. A mortgage that works for one person may not work for another because each person has different needs and are looking to get something different out of their home. So, before you talk to a mortgage company help yourself by becoming as educated as possible about the mortgages that are available to you.
Major Types of Mortgages
The most common mortgages are adjustable rate mortgages and fixed rate mortgages. An adjustable rate mortgage has just that, an adjustable interest rate that changes during the period of the loan. A fixed rate mortgage has an interest rate that stays the same throughout the entirety of the loan.
Each loan type has its own advantages and disadvantages. Understanding how each loan works and its pros and cons is the best way to determine which loan is right for you.
Adjustable Rate Mortgages
Adjustable rate mortgages are more complex than fixed rate mortgages so it’s important to understand how they work. Typically, at the beginning the interest rate is set below the current market rate and below that of a fixed rate. This low rate continues for a set period, usually three, five or seven years. After the initial time has passed then the interest rate will change at a pre-arranged frequency. This means your interest rate could change every month, every six months, every two years or even every ten years, it all depends on the specifics of your mortgage.
Two things determine what your new rate will be. The first is your rate index or adjustable index. This is the part of your mortgage that is always changing. The index is determined by a third party such as the Cost of Funds Index or the London Interbank Offered Rate and it can go up or down depending on what the index calls for.
The second is the margin. This is a set amount that you agree to pay at the time you sign your adjustable rate mortgage. The margin is added to the index to give you your current interest rate. For example, if the index for your loan is 4% and your margin is 2% then your interest rate will be 6%. Then if it’s evaluated again and the index drops to 1.25% then your interest rate would drop to 3.25%.
Most adjustable rate mortgages have caps which prevent the interest rate from going to high or increasing too much. Some even offer caps on how high your monthly bills can be. These are there to offer a small amount of protection from dramatic increases.
Adjustable rate mortgages are more uncertain then their fixed rate counterparts which is why it is very important to know the pros and cons of ARMs.
- The rates are low at the beginning of the loan making the payments low. This allows people to buy larger homes that they otherwise couldn’t buy.
- You can take advantage of lower rates without having to refinance. Where others must refinance and possibly pay a new set of closing costs and fees to get a lower rate, with an adjustable rate you can avoid these complications by just watching the rates decrease.
- The lower payments allow you to save and invest in other investments. If your payment is $100 lower a month because of a lower rate you can take that money and invest it into a higher-yielding opportunity.
- Adjustable rate mortgages offer a less expensive way to buy a home that you only plan on living in for a short amount of time.
- Just like the rates can fall they can increase to and they can increase a lot throughout the life of the loan. You could go from a 4% rate up to a 9% rate in just a few years.
- The first adjustment can be quite the shock. A lot of times the caps specified in the loan don’t apply to the first change. This means you could have a 7% cap, but your first initial change could still take you from 4% to 10% until it is re-evaluated, and the cap comes into effect.
- Adjustable rate mortgages are complex and can be hard to understand. If you don’t fully understand the terminology and how the loan works you could be taken advantage of by a less, then reputable mortgage company.
- Negative amortization loans are a form of adjustable rate mortgage where you can end up owing more money then you did at closing. Since the payments are set low, the monthly payment my only cover part of the interest due, the remainder is added to the principal balance making your overall loan higher than when you started.
Fixed Rate Mortgages
Fixed rate mortgages are not nearly as complicated as adjustable rate mortgages since you are dealing with one rate through the life of the loan. But they still have their own pros and cons:
- No matter what the economy does your rate and payment stay constant.
- The stability that a fixed rate mortgage gives you allows you to manage your money. With the same payment each month you know exactly what to budget.
- As we already discussed fixed rate mortgages are simple to understand. So, they are perfect for a first-time home buyer.
- In order to get a lower rate, you must refinance your current fixed mortgage rate. This means you would have to once again supply all the bank and tax information required for a loan along with spending time at the title company and paying closing costs.
- Since the rate can be high from the beginning of the loan it can be more expensive, and you don’t get an initial break.
- Fixed rate mortgages are also not as customizable. They do not vary from institution to institution. So, unlike an adjustable rate mortgage that can be customized to fit your needs, a fixed rate mortgage will be the same no matter what your needs are.
Becoming fully knowledgeable and learning all you can about adjustable rate mortgages and fixed rate mortgages can help you avoid costly mistakes in the future. After you weigh the pros and cons of each mortgage it’s also a good idea to consult a mortgage professional. With their help you can make sure that you choose the best mortgage for your needs.