So you’re in the market for a new home and shopping around for a mortgage. It’s unlikely you’re going to be paying cash for your new home so you’re going to be in the market for a mortgage. But how do you know what type of mortgage loan best suits your needs?
Let’s familiarize ourselves with the different types of mortgage loans so you can make the most informed decision possible.
Fixed Rate Mortgage
The standard “vanilla” home loan, a fixed rate mortgage comes with an interest rate that does not change over the course of the loan. It’s easy to budget for this type of loan because the monthly payments for principal and interest do not change (though your payment amount could change if your property taxes or homeowner’s insurance increase).
Fixed rate mortgages generally run for 30 years, though most lenders often different options. If you can afford it, a fifteen year mortgage will save you a ton of interest, plus it will be paid off in half the time. On the other end of the spectrum, if money is tight you can reduce your monthly payment (though you’ll pay more over the life of the loan) by choosing an extended loan period of 40 or even 50 years.
Adjustable Rate Mortgage (ARM)
As the name suggests, an adjustable rate mortgage is one in which the interest rate is not fixed. While the initial rate is generally lower than that of a fixed rate mortgage (which is why many people choose this option), the lender has the right to periodically adjust the rate, usually once a year.
The rate may go up or down so you need to be prepared to see your monthly payment increase. That could be a problem if your budget is already stretched thin, so it’s a good idea to leave enough wiggle room to allow for increases to your mortgage payment.
Take a fixed rate mortgage and combine it with an adjustable rate mortgage and you have yourself a hybrid ARM. The rate remains fixed for a certain amount of time and then it becomes adjustable. For example a 5/1 ARM will have a fixed interest rate for the first five years and then it adjust once a year after that.
With this type of home loan your monthly payment will remain low for an initial period of around five to seven years. When that initial period of time elapses the remaining balance comes due. The borrower must either pay back the entire balance remaining or refinance the loan.
Interest Only Mortgage
With this type of mortgage you pay only the interest on the loan for a specific period of time (usually the first few years). This allows you to keep your monthly payment very small at the beginning of the loan, but when the initial period is over your payment will skyrocket as you start paying back both principal and interest.
Many borrowers who took out interest only loans found themselves in trouble when the real estate market crashed. They had planned to refinance or flip the house before the interest only period ended, but when housing prices tumbled they ended up underwater on their mortgage and unable to get out.