The different types of mortgages available today can be placed in one of two categories. They either have a fixed rate of interest, or an interest rate that adjusts over time. Technically, there’s a third category of “hybrid” loans. But I’ll get to that later. As a home buyer, this is one of the first decisions you’ll have to make about the loan you want to use.
So how do you choose between these mortgage types? First, you need to understand how they work. Next, you need to consider the pros and cons of each type. And lastly, you should choose the loan that best supports your long-term housing plans.
Let’s start with the basics…
- Fixed-rate mortgage: This type of home loan carries the same interest rate for the entire term (length) of the loan. The interest rate makes up part of your monthly payment. It’s also the only component that has the potential to change over time. So if you get a mortgage with a guaranteed fixed rate, your monthly payment is guaranteed to stay the same — for the entire life of the loan.
- Adjustable-rate mortgage: These are also referred to as ARM loans for short. Unlike the previous option, this type of mortgage has an interest rate that changes over time. This also means that the size of your monthly payment will change over time. It might adjust up or down, depending on market conditions at the time of adjustment. But they usually adjust upward, resulting in a larger monthly payment.
- Hybrid ARM loan: Most of the adjustable-rate mortgages offered today are considered “hybrid” loans. They get this name because they start off with a fixed rate for a certain period of time. After that period, the rate will begin to adjust. The most popular example is the 5/1 ARM loan, which carries a fixed rate of interest for the first five years. The rate will change every year after that. Some lenders offer 1-year, 3-year and 7-year ARMs, as well.
You can probably see the benefit of using a fixed-rate loan. Your payments will never go up, no matter how long you stay in the house. But what about the ARM loan? Why would anyone choose a type of loan that has so much unpredictability? The answer lies within the initial savings.
During its initial fixed-rate period, the hybrid ARM generally has a lower interest rate than a traditional 30-year fixed-rate mortgage. So you could pay less money in interest during that time, if you went with the adjustable loan.