Mortgage & Equity
6 Mortgage Options
This section will discuss:
The two broad categories of mortgage types: fixed-rate and adjustable-rate.
The advantages & disadvantages of each of these types.
The word "mortgage" has its roots in the Old French for "dead pledge." It has a morbid ring to it. But learning all you can about mortgages before you apply for one will make them less threatening. Mortgages fall into two broad categories: fixed-rate and adjustable-rate.
Fixed-Rate
Here the interest rate remains the same throughout the length of the loan, whether that be 10, 15, 20 or 30 years. The big plus of a fixed-rate mortgage is that you know your monthly principal and interest payments won't change, right to the day when you make your last payment. Of course, your total monthly payments are apt to go up as property taxes and insurance premiums rise.
Adjustable-Rate
An adjustable-rate mortgage (ARM) has an interest rate that varies over the term of the loan. The starting interest rate is lower than the going market rate, but can increase (or decrease) a certain amount at specific intervals, such as once a year (or every six months, three years or five years). The interest rate on an ARM is pegged to some sort of financial index, such as the price of Treasury notes. The lender also will have a margin, the markup added to the index to determine the new rate at each adjustment. Usually there are two rate caps: one that limits how much the rate can be raised at each adjustment, and another that limits how much the rate can climb over the life of the mortgage. For example, an ARM may cap the annual increase at two percentage points and the lifetime increase at six percentage points. Thus, a 6 percent ARM could climb to no more than 8 percent after the first year, and to no more than 12 percent over the life of the loan.
Some ARMs are convertible. That is, you can convert to a fixed-rate mortgage at some specified time. Ask your credit union lender how long a window you would have for converting and what the fee would be.
ARM Advantages:
- You'll start out with a lower interest rate, and therefore smaller mortgage payments, in the early years when you're still getting on your financial feet.
- That lower rate may make it possible for you to qualify for a larger loan amount than you could get on a fixed-rate mortgage.
ARM Disadvantages:
- You gamble that in a few years you'll be able to handle larger payments if interest rates rise.
- You don't know how high the rate may climb up to the specified capped limit. Of course, it could decrease instead. But it's smart to look at the "worst-case scenario" (most lenders are required by law to disclose this) in deciding if you can handle an ARM.
Which Should You Choose?
That depends on you and your circumstances. Can you live with uncertainty about future rate changes? What income increases do you realistically expect in coming years? How long do you plan to live in the house? If you'll be moving in a few years, you might consider an ARM. But if you plan to stay put, a fixed-rate might be a better choice.
Other Variations: Other mortgage options exist. We will describe a couple of them here. (See also the government-backed loans discussed in the Down Payment section).
Two-Step Mortgage - This is a type of ARM in which the interest rate is adjusted only once (at the end of either five or seven years after settlement). The new rate then remains in effect for the remaining years of the loan.
Balloon Mortgage - The interest rate is fixed, and lower than the going market rate for a 30-year loan. But the remaining principal, or balloon, comes due after five or seven years, which means you must come up with the money or get a new mortgage at the then-prevailing interest rates.
