While the marketplace offers numerous varieties within these two categories, the first step when shopping for a mortgage is determining which of the two main loan types best suits your needs.
A fixed-rate mortgage charges a set rate of interest that remains unchanged throughout the life of the loan. Although the amount of principal and interest paid each month varies from payment to payment, the total payment remains the same, which makes budgeting easy for homeowners.
The partial amortization schedule below demonstrates the way in which the amounts put toward principal and interest alter over the life of the mortgage.
As you can see, the payments made during the initial years of a mortgage consist primarily of interest payments. The main advantage of a fixed-rate loan is that the borrower is protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise. Fixed-rate mortgages are easy to understand and vary little from lender to lender. The downside to fixed-rate mortgages is that when interest rates are high, qualifying for a loan is more difficult because the payments are less affordable.
Traditional lending institutions offer fixed-rate mortgages for a variety of terms, the most common of which are 30, 20, and 15 years. The year mortgage is the most popular choice because it offers the lowest monthly payment. However, the trade-off for that low payment is a significantly higher overall cost, because the extra decade, or more, in the term is devoted primarily to paying interest.
The monthly payments for shorter-term mortgages are higher so that the principal is repaid in a shorter time frame. Also, shorter-term mortgages offer a lower interest rate, which allows for a larger amount of principal repaid with each mortgage payment. Thus, shorter term mortgages cost significantly less overall.
For more, see Understanding the Mortgage Payment Structure. The interest rate for an adjustable-rate mortgage is a variable one. The initial interest rate on an ARM is set below the market rate on a comparable fixed-rate loan, and then the rate rises as time goes on. If the ARM is held long enough, the interest rate will surpass the going rate for fixed-rate loans.
ARMs have a fixed period of time during which the initial interest rate remains constant, after which the interest rate adjusts at a pre-arranged frequency. The fixed-rate period can vary significantly—anywhere from one month to 10 years; shorter adjustment periods generally carry lower initial interest rates.
After the initial term, the loan resets, meaning there is a new interest rate based on current market rates. This is then the rate until the next reset, which may be the following year. ARMs are significantly more complicated than fixed-rate loans, so exploring the pros and cons requires an understanding of some basic terminology.
Here are some concepts borrowers need to know before selecting an ARM:. The biggest advantage of an ARM is that it is considerably cheaper than a fixed-rate mortgage, at least for the first three, five, or seven years. ARMs are also attractive because their low initial payments often enable the borrower to qualify for a larger loan and, in a falling-interest-rate environment, allow the borrower to enjoy lower interest rates and lower payments without the need to refinance the mortgage.
A borrower who chooses an ARM may save several hundred dollars a month for up to seven years, after which their costs are likely to rise. The new rate will be based on market rates, not the initial below-market rate. If you're very lucky, it may be lower depending on what the market rates are like at the time of the rate reset.
The ARM, however, can pose some significant downsides. With an ARM, your monthly payment may change frequently over the life of the loan. This is a fee that can be charged if you sell or refinance the loan.
If you plan on selling the home or refinancing within the first five years of the mortgage, you should choose a lender who offers a loan without this penalty. ARMs can have complicated rules, fees and structures.
How does an adjustable-rate mortgage work? The pros of an of adjustable-rate mortgage. Low payments in the fixed-rate phase. Rate and payment caps. Your payments could decrease. The cons of an adjustable-rate mortgage. Develop and improve products. List of Partners vendors.
An adjustable-rate mortgage ARM is a type of mortgage in which the interest rate applied on the outstanding balance varies throughout the life of the loan.
With an adjustable-rate mortgage, the initial interest rate is fixed for a period of time. After that, the interest rate resets periodically, at yearly or even monthly intervals. ARMs are also called variable-rate mortgages or floating mortgages. Typically an ARM is expressed as two numbers. In most cases, the first number indicates the length of time the fixed-rate is applied to the loan.
If you're considering an adjustable-rate mortgage, you can compare different types of ARMs using a mortgage calculator. At the end of the initial fixed-rate period, ARM interest rates will become variable adjustable , and will fluctuate based on a some reference interest rate the ARM index plus a set amount of interest above that index rate the ARM margin. The ARM index is often a benchmark rate such as the prime rate , the rate on short-term U. Treasuries, or the Fed Funds rate. Although the index rate can change, the margin stays the same.
Unlike adjustable-rate mortgages, traditional or fixed-rate mortgages carry the same interest rate for the life of the loan, which might be 10, 20, 30 or more years. They generally have higher interest rates at the outset than ARMs, which can make ARMs more attractive and affordable, at least in the short term. However, fixed-rate loans provide the assurance that the borrower's rate will never shoot up to a point where loan payments may become unmanageable.
FHA loans can help borrowers with less-than-ideal credit and small down payments. A cash-out refi lets you tap your home equity in cash. Pay a little more every month, and cut your mortgage interest by a lot. See rates from our weekly national survey of CDs, mortgages, home equity products, auto loans and credit cards.
Glossary A Adjustable-rate mortgage Adjustable-rate mortgage Adjustable-rate mortgage is a money term you need to understand. What is an adjustable-rate mortgage?
Deeper definition Traditional fixed-rate mortgages have an interest rate agreed upon at the time of closing that remains in place throughout the entire term of the loan.
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