Getting the Mortgage That's Best for You
The two most common types of mortgages are fixed-rate and adjustable-rate. There are some other kinds that we'll mention briefly, but fixed-rate and adjustable-rate are the big two.
Fixed-rate mortgages are the most common kind of mortgages—sort of the industry standard—and they're the easiest to understand. You agree to pay a certain amount of interest on your mortgage for as long as you have it. If you pay 7 percent interest the first month, you'll pay 7 percent interest the last month, too. The rate doesn't change and neither does your monthly payment. You'll receive a schedule of payments, and you'll know exactly how much you'll pay each month. So if you like to know exactly how to plan your long-term budget, you'll probably like fixed-rate mortgages. It removes the guesswork.
Show Me the Money
A fixed-rate mortgage is one where the interest rate remains constant over the life of the loan. An adjustable-rate mortgage is one where the interest rate normally stays the same for a specified amount of time, after which it may fluctuate.
Show Me the Money
Refinancing your mortgage is trading in your old mortgage for a new one. People refinance to get better interest rates, and thus lower their monthly payment, and/or shorten the term of the loan, or to change their mortgage from one type to another.
Interest rates a lender charges on a mortgage, or any loan, change because of the general economic environment, usually dependent on inflation. Interest rates are controlled by the Federal Reserve, through the interest rates that this federal agency charges to banks. If the Feds charge banks high interest, your mortgage rate will be high; if rates are low, a mortgage you take out should have a low rate.
A problem with fixed-rate mortgages, though, is that if the interest rates drop dramatically, you're still stuck paying the higher rate. You can refinance your mortgage to take advantage of low rates, but this process requires time and involves significant expense for things such as appraisals, title insurance, points, and the like. These fees can easily add up to $3,500 or $4,000. When you refinance your mortgage, you're basically trading it in for a new one. Still, there are reasons why more people have fixed-rate mortgages than any other kind. They're easy to keep track of, and you can count on a specific payment you'll make each month. Let's have a look at how the other kinds compare.
Adjustable-rate mortgages (ARMs) are different from fixed-rate mortgages because the interest rate doesn't stay the same for the entire term of the loan. Because of that, your monthly mortgage payment varies. Homebuyers generally are attracted to ARMs because they offer initial savings. You often can get an ARM without paying points, which are the fees (actually prepaid interest) you pay your mortgage lender to cover the cost of completing the mortgage application. Also, the beginning interest rate of an ARM is normally lower than the rate for a fixed-rate mortgage.
You generally agree to pay a fixed interest rate for a certain amount of time, after which your rate and monthly payment may start to fluctuate. The interest rates for ARMs are tied into various indexes, which determine how they'll rise or fall. The indexes used for the interest adjustment are based on the current interest rate scenario evident at the time the ARM rate is adjusted. Whatever index is used will be specified by the lender. Most ARMs also include annual caps, so your interest rate can't keep increasing forever. You could, however, end up paying hundreds of dollars more on your monthly payment down the road than you do initially if the interest rates rise dramatically. On the other hand, if interest rates stay low, an ARM can be a good deal.
During the last several years, interest rates dropped to a 45-year low, and ARMs aren't as popular right now as they were when interest rates were higher. The difference between an ARM and a fixed-rate mortgage is minimal these days, compared to as much as a 4-point difference back in the days when mortgage rates were up at around 9 percent.
The following are two of the more common types of available ARMs:
- A 7/1 ARM has an initial rate that's locked in for seven years. The rate can change every year after that.
- In a 3/3 ARM, the initial rate is locked in for three years, then the rate can be adjusted every three years. It can be raised 2 percent at a time, with a 6 percent increase cap for the life of the loan.
Fortunately for the buyer, most ARMS offer caps that protect against really huge increases in payments. There are different kinds of caps:
- A lifetime cap limits how much the interest rate can rise over the life of the loan.
- A periodic rate cap limits how much your payments can rise at one time.
- A payment cap limits the amount that your payment can rise over the life of the loan.
The initial savings of an adjustable-rate mortgage over a fixed-rate mortgage can be tempting. Don't get sucked into an adjustable-rate deal, however, unless you fully understand how it works and are willing to take the risks.
Which Is Better: Fixed-Rate or Adjustable?
If you're trying to decide between a fixed-rate or adjustable-rate mortgage, it's good to get all the information you can about each. After you have a pretty good understanding of the differences between the two types of mortgages, ask yourself these questions:
- How long do you plan to live in the home you're buying?
- How often does the ARM adjust and when is the adjustment made?
- How high could your monthly payments get if interest rates were to rise?
If you're only going to live in the house for a few years, an ARM might make more sense than a fixed-rate mortgage. Remember, the initial interest rate usually is lower with an ARM, and you might be able to avoid paying points. If you're only going to live in the house for three years, and your interest rate can't be adjusted within that time, you may be able to get a good deal with an ARM.
More than three quarters of the people who get mortgages choose fixed-rate mortgages.
After the initial, fixed period, during which time the interest rate on an ARM can't change, most ARMs adjust every year on the anniversary of the date you closed on the mortgage. A 3/3 ARM means you'd have the initial payment for three years, after which it can be adjusted every three years. You're normally notified of your new rate about 45 days before it takes effect.
Suppose you have an ARM with a cap that allows your interest rate to jump 2 percent a year, with a lifetime cap of 6 percent. If you have a $100,000 mortgage, and started with an interest rate of 5.75 percent, your monthly payments could jump more than $400 by the time your lifetime cap kicks in. Quite a hammering, isn't it? In that case, and that's a worst-case scenario, you'd be better off having a fixed-rate mortgage. Economists and financial experts who study these things say that if you can get a good fixed rate, you're probably better off with it, even if you don't plan to stay in the house too long.
The following table shows the different monthly mortgage payments and the differences in total income paid for mortgages at different interest rates. Quite a difference!
|2% adjustment, permitted 4 times (6% maximum increase in rate)|
|5% rate||$ 402.62/month||$ 4,831.44/year|
Dollars and Sense
Before assuming an adjustable-rate mortgage, figure out what the highest possible, worst-case scenario payment could be. If you don't think you could swing it, go for a fixed-rate mortgage.
Before you choose a fixed-rate or adjustable-rate mortgage, you need to determine how comfortable you are with risk. If you choose an ARM, and your interest rate zooms up, will you be able to afford the higher payments? Do you have an emergency fund you could borrow from if you had trouble? Are you likely to be incurring additional expenses soon? Do you need to buy a new car, or are you planning on starting a family? Are you sure your income will continue rising, or is it possible that it will decrease?
These are all questions you'll have to think about and answer before making a decision. An ARM can pay off, but it's a gamble. Some-times there's a lot to be said for something that's safe and dependable, like a fixed-rate mortgage.
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Excerpted from The Complete Idiot's Guide to Personal Finance in your 20s and 30s © 2005 by Susan Shelly and Sarah Young Fisher. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.
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