Buyers can easily get overwhelmed by the options they are confronted with when it is time to apply for a loan. Conventional? Government-backed? Fixed rate? Adjustable rate? Even within these categories there can be several options.
Before you can determine which loan is right for you, you need to have an understanding of how each work and the costs and benefits of each. Let’s start with definitions:
Fixed Rate Mortgage
Fixed rate mortgages are exactly that – the mortgage rate remains fixed for the life of the loan. Monthly payments are fixed (for the principle and interest – if property taxes and homeowners insurance are paid as part of your payment, these are paid through an “escrow” account which can fluctuate from year to year).
Adjustable Rate Mortgage
These are also called ARMs. This type of loan has the potential to have monthly payments that change since the interest rate can change. There is usually an initial period of time where the interest rate does not adjust. This might be a “1-year” ARM, 3-year, 5-year, or 7-year. How often the interest rate adjusts will also depend on the loan. Since interest rates do change over time, the payment can either be higher or lower depending on the difference in the interest rate. For example, if someone took out a loan now when interest rates are at record-low levels, it is unlikely that interest rates will continue to be this low when the interest rate adjusts. Furthermore, ARMs generally start out with a lower interest rate than a fixed rate loan.
It is important to know your future plans when determining the type of loan which is ideal for you. For example, if you are planning on staying in your home for only seven years, it might save you money to use an adjustable rate mortgage with the expectation that you will be moving and taking out a new loan before the interest rate is adjusted. However, what happens if there is a health issue or something else which prohibits you from moving in seven years? What if you cannot move into a fixed-rate mortgage? These things must be taken into consideration when determining whether you can afford your monthly payment – now and later.