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Types of Mortgages

There are different types of mortgages (fixed and adjustable rate), but which is the best for you?

With the recent housing crunch and historically low interest rates for home mortgages, it's certainly a buyer's market. Even if you're in a position to take advantage of the low home prices and low interest rates, though, you still have to decide which of the different types of mortgages available will best serve your interests?

In this article, we'll briefly discuss what fixed rate mortgages and adjustable rate mortgages are, their differences, and the advantages and disadvantages of each. The final decision between the two different types of mortgages will depend upon your financial situation and your personal comfort level with risk, but this article will cover the basics so that you can make a more informed decision.

Fixed Rate Mortgages

The interest rate and the amount you pay each month is always the same with a fixed rate mortgage. Terms are typically 15 or 30 years, though you can negotiate with your lender for a shorter term.

Fixed rate mortgages are the equivalent of a luxury car--very reliable, but you'll pay a premium for that comfort. Your monthly payments of interest and principal will be exactly the same for the life of the loan, but the interest rate you'll pay for the term of a fixed rate mortgage is generally about 1 percentage point above what you would pay for an adjustable rate mortgage (ARM). By paying that extra pecentage point, however, you'll be protected against the chance that interest rates will rise during the loan term.

Adjustable Rate Mortgages

An adjustable rate mortgage is a loan with an interest rate that changes during the term of the loan. The interest rate that you pay is determined by the prime index rate, which is set by various financial indexes (each ARM will identify which index your loan tracks). If the prime rate goes down, so does the interest that you pay on your loan. And when the prime rate goes up, so do your loan payments.

Typically, ARMs will limit, or cap, the amount and frequency of interest rate changes so that mortgage holders are not subjected to wild and frequent changes in their loan payments. This cap also serves to minimize the bank's losses in the event interest rates become very low, as was the case in mid- to late- 2009 and continuing into 2010.

Advantages of Fixed Rate Loans

Of the different types of home loans, fixed rate loans are the most reliable. They protect homeowners from fluctuations in interest rates and provide stability in payment. Every single month, at the exact same date, for the entire life of the loan, you will pay the exact same amount to the bank.

While fixed rate loans provide reliability, you'll likely pay a bit more for the protection afforded against rising interest rates. For those homebuyers who are more risk-averse, fixed rate loans are likely the best route. When interest rates are low (as they have been during the housing crunch), you can refinance your loan to lock in the lower rate. For more on refinancing, see below.

Advantages of Adjustable Rate Mortgages

The first advantage of ARMs are that your monthly payments, at least for a time, will likely be lower than fixed rate mortgages. These rates could also stay lower if interest rates remain the same or dip even lower. For example, during this prolonged housing crunch, interest rates have gone steadily lower and are currently at historically low levels. Those with ARMs have benefitted by paying less in interest each month (although because of interest caps, it's likely that ARM holders haven't been able to take full advantage).

Some lenders will offer lower, discounted introductory interest rates for ARMs than for fixed rate loans. This means that for a period, mortgage holders pay an even lower amount each month, which is obviously beneficial to your wallet. Once these discounted rates end, however, you may be in for sticker shock, as your payments will start to reflect the true interest rate, as well as any adjustment upward in the event interest rates have risen during your introductory term.

It is possible that you'll actually pay less interest over the term of the loan than you would with a fixed rate mortgage. This could happen if interest rates remain the same or decline. In fact, some studies have shown that homeowners have paid less on average with ARMs than fixed rate loans.

Against these possible advantages, however, you'll have to balance the chances that your payments could rise substantially (particularly if you opt for a discounted ARM) and your payments may not go down significantly even if interest rates drop (due to interest caps). Additionally, many ARMs have a penalty for paying off the loan early.

The Best Option for You

As you can see, both types of mortgages have advantages and disadvantages. At a base level, if one or the other sounded better to you, it may be best to go with your instinct, because choosing the right mortgage for you really boils down to your financial situation and your comfort with varying levels of risk.

Factors which you should consider and questions you should ask about the different types of mortgages include:

  • the current prime interest rate and what rate different lenders are willing to offer you
  • whether you believe interest rates are headed up or down
  • how long you intend to stay in the home (if it's only a short time, rising interest rates may not bother you too much)
  • will your income rise enough in the future to offset a potential rise in rates?
  • your comfort with risk

Without a doubt, when interest rates are very low (as they have been for some time), it is best to lock in a fixed rate mortgage at a low rate. By doing so, you guarantee yourself low fixed rates and protect yourself against rising future rates.

If, on the other hand, you only intend to own the home for short period of time, ARMs may be useful because you save in the short term and don't have much concern for the future. The risk here is that if the housing market continues its slump, you may not be able to sell your home as quickly, or at the price, you desire, which would mean you'd be stuck with a rising ARM for an unknown period of time.

ARMs may also be attractive to those who expect an increase in income level in the future. ARMs offer low out of pocket costs at the beginning of the term and if your income level rises, you will be better able to afford potential increased rates while still having the ability to purchase the house at the present time. Of course, banking on an increase in income before it actually happens is a risky proposition.

At the end of the day, your choice will be made after an analysis of your financial situation and goals, and your comfort with risk. If you're the type of person who will lose sleep over a quarter of a percentage point increase in interest rates or have anxiety over potentially increased monthly bills, a fixed rate mortgage is probably for you. If you're comfortable with risk, you may wish to take an ARM. Some studies have indicated that ARMs are actually less costly in the long run than ARMs, but the risk of increasing rates is always a big concern.

Refinancing Fixed Rate Mortgages

Refinancing fixed rate mortgages is a method by which fixed rate mortgage holders can adjust their rates in the event interest rates drop. Banks will refinance the current mortgage at a lower interest rate than the original loan.

This adjustment comes with a price, however. There are fees associated with the refinancing, so it may take a few years to recoup those fees and actually start saving money from the refinancing. On average, you should expect to pay three to six percent of the outstanding balance on refinancing fees.

Additionally, you may lose some rights by refinancing. If you default on a home mortgage, the bank forecloses on your home and tries to sell it to recoup its investment. You don't lose anything other than the home (and the hit on your credit, of course). But if you refinance your mortgage, some states allow the bank to come after some of your other assets (cash, car, etc.) in order to satisfy the difference in the selling price of the house and the mortgage.

Refinancing can be a very useful tool, but consumers should be aware that there is a certain element of risk involved.

Next Steps
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