With mortgage rates at 20-year highs, it has become imperative that home buyers understand the different types of mortgages available to them. And like homes themselves, mortgages come in many shapes and sizes. Whether fixed or adjustable, the type of mortgage that’s right for you depends on many factors, such as risk tolerance and how long you expect to stay in your home.
Fixed Rate Mortgages
Fixed-rate mortgages are popular because loan payments are predictable – the interest rate on a conventional fixed-rate mortgage remains the same throughout the length of the loan. Over the term of the loan, usually 15 or 30 years, your monthly payment remains the same. As your loan balance decreases, more of your monthly payment goes towards paying down the principal rather than towards interest. One risk inherent to fixed-rate loans is that your interest rate does not decrease if market interest rates decrease. However, you can get around this issue by refinancing your loan to a lower interest rate. While refinancing can be time-consuming and involves some costs, it is well worth the time and money if the lower rate significantly decreases the lifetime interest that you pay. Overall, fixed rate mortgages are usually more suitable for those who plan to stay in their homes long-term and prefer a predictable payment.
Adjustable Rate Mortgages
With an adjustable rate mortgage, or “ARM,” your interest rate is adjusted periodically, usually annually, based on changes in market interest rates. Since the length of the loan remains constant, the payment necessary to pay off your loan by the end of the term changes as your loan’s interest rate changes. Therefore, the monthly payment is recalculated with reach interest rate adjustment. To adjust the interest rate, the lender uses an index that reflects general interest rate trends, such as the one-year treasury securities index, then adds a margin to reflect the lender’s profit. For example, if the index is at 5% and the margin is 2%, the ARM interest rate comes to 7%.
Most ARMs specify interest rate caps. However, a word of caution: some ARMs cap the payment amount that you are required to make, but not the interest rate. With these loans, it’s important to note that payment caps can result in negative amortization during periods of rising interest rates, such as today’s environment. If your monthly payment is less than the interest accrued that month, the unpaid interest is added to your principal, and your outstanding balance would actually increase, even though you made your required monthly payments.
Hybrid ARMs offer a fixed interest rate for a certain time period such as 7 or 10 years, then convert to a regular adjustable rate mortgage that adjusts the interest rate annually. The initial fixed interest rate on a hybrid ARM is often considerably lower than the rate of a 30-year fixed-rate mortgage. Hybrid ARMs are ideal for those who plan to stay in their homes for a short period of time (5-10 years), since they can take advantage of the low initial fixed rate without worrying about how the loan will change when it converts to an adjustable rate mortgage. If your plans to move may change, you can consider a hybrid ARM with a conversion option, which allows you to convert your loan to a fixed-rate loan before it turns into an adjustable rate loan. Overall, ARMs and Hybrid ARMs are more suitable for those who are comfortable with the risk of interest rates increasing, perhaps because they intend to move homes within a certain number of years.
Which type of mortgage you choose should be tailored to your individual financial situation and goals, considering your time horizon, risk tolerance, and cash flow. A qualified financial advisor can help you to make this decision as part of a broader financial plan that works for you.