One of the first choices a homebuyer will need to make is whether you want a fixed-rate or an adjustable-rate mortgage loan.
Fixed-Rate Mortgage Loans vs Adjustable-Rate Mortgage Loans
Fixed-Rate mortgages (FRMs) and adjustable rate mortgages (ARMs) are the two primary mortgage types. 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 – the fixed-rate mortgage or the adjustable-rate mortgage – best suits your needs.
A Fixed-Rate mortgage charges a set rate of interest that does not change 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.
There is typically a tradeoff when it comes to choosing a mortgage between risk and reward, or between an adjustable rate mortgage and a fixed-rate mortgage. Depending on market conditions (the shape of the yield curve), an adjustable-rate mortgage might have a large initial payment advantage over a fixed-rate mortgage. However, if such a scenario exists, there is a probability that the payments on the adjustable-rate mortgage will rise over time. Mortgage borrowers need to understand and measure risks when deciding between an adjustable-rate and fixed-rate mortgage.
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.
Although the rate of interest is fixed, the total amount of interest you'll pay depends on the mortgage term. Traditional lending institutions offer fixed-rate mortgages in a variety of terms, the most common of which are 30, 20 and 15 years.
The 30-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 higher 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, so shorter-term mortgages cost significantly less overall.
The interest rate for an adjustable-rate mortgage varies over time. 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 3, 5, 7 up to 10 years. Shorter adjustment periods generally carry lower initial interest rates.