Choosing A Mortgage

Introduction

Like homes, home mortgages come in all shapes and sizes: short-term, long-term, fixed, adjustable, jumbo, balloon--these are all terms that will soon be familiar to you, if they're not already. There's a mortgage out there that's right for you. To figure out which one, though, you'll want to take into consideration such factors as your risk tolerance, the length of time you plan on staying in your home, whether you're looking for a mortgage with low up-front costs, and the size of the mortgage you need.

Fixed rate mortgages

As the name implies, the interest rate on a fixed rate mortgage remains the same throughout the life of the loan. Your monthly payment (consisting of principal and interest) generally remains the same as well. The entire mortgage is repaid in equal monthly installments over the term (length) of the loan.

Length does make a difference

In the mortgage market, long-term loans are generally considered to be 30 or more years in length; short-term loans are those under 30 years in duration. While they may vary between 10 and 40 years (depending in part on the size of the loan), the usual terms for fixed rate mortgages are 15 and 30 years. Although the monthly payment for a 15-year mortgage will be higher than the monthly payment for a 30-year mortgage, it won't be twice as high, and the shorter term of the loan will save you a substantial amount in total interest charges.

Example(s): If you borrow $100,000 at 8 percent for 30 years, your monthly principal and interest payment will be $733. Over the 30-year term, you'll pay a total of $164,155 in interest. If you borrowed the same amount at the same interest rate for 15 years, your monthly payment would be $955 (about 30 percent higher than the payment for the 30-year mortgage), and the total interest you'd pay over the 15-year term would be $72,017--a savings of $92,138.

Because the lender would lose money on a long-term fixed rate loan if interest rates were to rise, the lender may adjust the rate accordingly, in effect charging you a premium to offset this possibility. As a result, a 30-year mortgage may have a higher fixed interest rate than a 15-year loan, and both will carry higher interest rates than those initially charged on an adjustable rate mortgage (ARM).

The good news is, you're locked in; the bad news is, you're locked in

Locking in a fixed interest rate on your mortgage has its good and bad points. If interest rates rise, yours won't; as a result, your monthly mortgage payment will always remain the same. This can be reassuring to homeowners on tight budgets or with fixed incomes. For this reason, fixed rate mortgages often appeal to individuals with a low tolerance for the risk associated with fluctuating monthly payments.

But if interest rates go down, yours won't, and your (now high) mortgage payment will remain the same. While you might be able to refinance your home, paying off the higher-rate mortgage with one that carries a lower interest rate, this isn't always possible. In addition, the interest rate might need to drop significantly to offset the expenses associated with refinancing, and you'd need to remain in your home long enough to allow the monthly savings associated with the lower rate to recoup those expenses. For more information.

Adjustable rate mortgages (ARMs)
In general

With an ARM, also called a variable rate mortgage, your interest rate is adjusted periodically, rising or falling to keep pace with changes in market interest rate fluctuations. Since the term of your mortgage remains constant, the amount necessary to pay off your loan by the end of the term changes as your loan's interest rate changes. Thus, your monthly payment amount is recalculated with each rate adjustment.

Example(s): You have a $100,000 ARM with an initial interest rate of 6.5 percent and a 30-year term. Your monthly mortgage payment (in whole dollars) is $632. The interest rate is adjusted annually. At the end of the first year, the interest rate increases to 8.5 percent. To reflect this increase and to repay the outstanding principal balance over the remaining 29 years in the term, your payment will increase to $766 per month. If at the end of the second year the interest rate increases to 10.5 percent, your payment will increase to $906 per month.

Depending on what's specified in the mortgage contract, an ARM can be adjusted semi-annually, quarterly, or even monthly, but most are adjusted annually. The adjustments are made on the basis of a formula specified in the mortgage contract. To adjust the rate, the lender uses an index that reflects general interest rate trends, such as the one-year Treasury securities index, and adds to it a margin reflecting the lender's profit (or markup) on the money loaned to you. Thus, if the index is 5.75 percent and the markup is 2.25 percent, the ARM interest rate would be 8 percent.

What's to keep the interest rate from going through the roof--or, for that matter, from plunging through the floor? Most ARMs specify interest rate caps. The periodic adjustment cap may limit the amount of rate change, up or down, allowed at any single adjustment period. A lifetime cap may indicate that the interest rate may not go any higher--or lower--than a specified percentage over--or under--the initial interest rate.