While the mortgage process can be quite intimidating at first, the loan choices available to you are actually rather straightforward. Here are your two main choices, and tips on deciding which is best for you.
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Two Flavors of Mortgages
Fixed-rate and adjustable-rate mortgages are the two main types of mortgages of the home-lending world.
Fixed-rate loans: A fixed-rate mortgage is very straightforward. As the name implies, these loans have an interest rate that doesn't change and a set amount of time until the loan is paid off. The borrower knows from the beginning what the interest rate will be for the entire duration of the mortgage, and the monthly payments due are likewise fixed.
By far, the most popular fixed-rate mortgage is the 30-year mortgage, but they also come in 15-year terms, 20-year terms, and others.
Adjustable-rate loans: An adjustable-rate mortgage, or ARM, is slightly less straightforward. Basically, an adjustable-rate loan will start with a low "teaser" interest rate for a set number of years, and after that, the rate will adjust depending on current market rates and the terms of your loan.
There are ARMs offered for a variety of initial rate periods (e.g., 3-year or 5-year ARMs), as well as rate-adjustment rules (such as a maximum of 2% at a time), but they generally all work the same way: Let's say you get a 5/1 ARM. That means you'll have a fixed rate for the first five years, and after that, your rate will reset once a year. If rates are plummeting, your rate will also drop -- and vice versa.
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Which Loan Type Is Right for You?
The exact loan that is right for you depends on a variety of factors. Here's guidance on determining which way to go.
A fixed-rate mortgage may be right for you if...
- You don't like surprises: Fixed-rate mortgages are good for people who enjoy stability. Since the rate is locked in from the get-go, you are not exposed to any long-term risk if interest rates rise.
- You think interest rates may increase in the future: They're especially attractive during periods when interest rates are low.
- You are going to stay in the house for a while: If you've found your "forever" home -- or at least your "let's settle down and see how it works out" home -- then it makes sense to commit.
- You are willing to pay a slightly higher interest rate for stability: In exchange for essentially allowing you to lock in a rate for a long period of time, you'll often pay a slightly higher rate for a fixed-rate mortgage than you would with an ARM.
An adjustable-rate mortgage may be right for you if...
- You think rates are more likely to fall than rise: If rates do go down when it's time for your ARM to adjust, then your mortgage payment will dip with it.
- You want to stretch your dollar in the beginning: Since ARM rates are typically slightly lower than fixed rates, the difference may help you buy a slightly spiffier house.
- You don't plan to stay in the house for long: ARMs are often recommended for those who will be in a house for only a few years (or move before the initial teaser rate expires), since the rate is not likely to change too much in that time.
- You're sure you can handle it if your rate quickly rises to the cap: Do not enter into an ARM unless you are prepared for a worst-case-scenario where interest rates suddenly shoot sky-high right as your mortgage rate is about to adjust.
The Bottom Line
The conventional fixed-rate mortgage is not just predictable -- with rates at historic lows, it's also cheap. Unless you're planning to sell your house before the initial teaser rate on an ARM expires, a fixed-rate is the way to go for pretty much all homebuyers.
The article How Should I Choose Between a Fixed-Rate Mortgage and an ARM? originally appeared on Fool.com.
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