Fixed-Rate Mortgages | Adjustable-Rate Mortgages
Other Mortgage Types
A Fixed Rate Mortgage is one in which the rate remains the same across the life of the loan. The advantage is that monthly payments will remain the same. However, if you lock into a higher interest rate, the rate will not change, even if interest rates go down in the future.
The lowest monthly payments come from 30-year fixed-rate mortgages. However, these mortgages also take longest to build up equity in your home. Experts recommend a 30-year mortgage if you are planning to stay in your home for several years and want a stable rate.
Also common are 15-year fixed-rate mortgages. These loans spread the principal and interest across a 15-year period, after which you have paid off your loan. Because of the shorter term of the loan, you can build up equity in your home at a much faster pace. However, monthly payments are higher than for a 30-year fixed-rate mortgage. Experts recommend a 15-year fixed-rate mortgage if you are planning to sell your home in a few years and want a stable rate.
Adjustable-Rate Mortgages, or ARMs as they are commonly called, are ones in which the interest rate changes periodically according to a fixed index. A 1-year ARM adjusts the interest rate annually. Monthly payments will increase or decrease along with the index rate, which is specified by the mortgage. Common indices include 1-year Treasury notes, Federal funds rate and the national cost of funds index. A margin -- usually one or two percentage points -- is added to the index rate.
Adjustable-rate mortgages include two caps on the amount the rate can increase or decrease. One cap limits the interest rate adjustment in any one adjustment period (e.g. one year in a one-year ARM), and the second cap limits the interest rate adjustment across the lifetime of the loan.
The advantage of an adjustable-rate mortgage is that monthly payments can decrease when the index goes down. However, monthly payments will increase when the index goes up.
One way of shortening the length of your mortgage is to purchase a balloon mortgage. It works like an ARM or a fixed-rate mortgage for the first several years. After that period of time has expired, you owe a large payment -- sometimes the remaining balance on the loan. The advantage of this type of loan is that it keeps monthly payments low. Experts recommend this type of loan for people who are planning to sell their homes within a few years, and can pay off the balloon payment from the proceeds of the sale of the house.
A convertible loan is an ARM that can be converted to a fixed-rate mortgage after a specified number of years. There may be a cost associated with this.