Home mortgage rates come in two basic forms: fixed-rate and adjustable-rate. Understanding the difference is the best way homeowners can make an informed decision about which type of mortgage is right for them.
Typical fixed-rate loans traditionally have a repayment term of 15, 20, or 30 years, though some lenders now offer 10- and 50-year terms.
The greatest benefit of a fixed-rate loan is that the interest rate and the monthly payment remains the same throughout the life of the loan. Though the interest and principal will vary from month to month due to amortization, changes in the market have no effect on your loan.
The most common fixed-rate home mortgage is a 30-year loan, which amortizes over thirty years. Amortization is simply the act of paying off your debt in regular installments over a set period. In the case of home loans, your monthly payments initially go toward paying down the interest on the loan. Toward the end of the 30-year term, your monthly payments primarily pay off the principal.
For example, here is how the principal and interest vary over the first several payments on a 30-year mortgage with an initial loan of $100,000 and a 6.0% interest rate.
Because of the set nature of fixed-rate loans, the interest rates are generally higher than adjustable-rate mortgages, but there is no risk of the interest rate changing in the future.
Adjustable-Rate Mortgage (ARM)
Adjustable-rate loans, sometimes referred to as variable-rate loans, typically offer a lower initial interest rate. Unlike fixed-rate mortgages, the interest rate fluctuates with the market, and so will your monthly payment.
In addition to a lower initial interest rate, ARMs are generally easier to obtain than fixed-rate loans; however, the risk is when interest rates rise, so does your monthly payment.
To counterbalance this, adjustable-rate loans have caps, a limit on how high the interest rate can increase. On the other hand, ARMs adjust downward when interest rates fall.
Here’s how adjustable-rate loans work. When the initial interest rate period expires, a new interest rate is calculated by adding a margin (a fixed percentage rate) to the index (there are several popular mortgage indexes). Your lender is responsible for providing you with this information. Margins usually differ from lender to lender, so you’ll want to shop around.
Due to the uncertainty of an adjustable-rate loan, be sure you know:
- How long the current interest rate applies
- What the new interest rate will be
- How often the interest rate adjusts
- The maximum amount your monthly payment could increase
- The payment cap
- If there are any penalties for paying the loan off early
For more information on adjustable-rate loans, check out the Federal Reserve Board’s “Consumer Handbook on Adjustable-Rate Mortgages.”
Other Forms of Home Mortgages
There are other types of mortgages available, but they are used less frequently. These include:
- Interest-only mortgage: Unlike traditional mortgages where you pay both interest and principal, with an interest-only mortgage you pay only the interest for a certain number of years. Then at a specified point, you start paying both.
- Graduated-payment mortgage: A fixed-mortgage with a gradually increasing payment.
- Balloon-payment mortgage: Because the loan amount is not fully amortized, a large balance – known as a balloon-payment – is due at the end of the loan.
- 203K mortgage: Related to the Section 203(k) program run by the federal government for single-family properties that require repair and rehabilitation.
Which is the Best Loan for You?
Choosing the best loan for you will depend on a number of factors, including the current housing market and your personal situation. You might want to start by asking these questions:
- How long do you plan to keep the home?
- What is the current market for interest rates and home loans?
- Does your income allow for fluctuating interest rates?
- How much can you afford to borrow?
One of the most important things you can do is to shop around and compare. Talk to lenders and brokers, conduct research, and consider all your options before you make a commitment.