The two primary types of mortgage loans are the fixed-rate mortgage and the adjustable-rate mortgage. Some lenders actually sell a variety of hybrid loans or mortgages that offer a mixture of benefits from each, but these are the most common loan types. Learning the pros and cons of each is important since a home loan is a major financial investment.
A fixed-rate mortgage means your interest rate on the loan stays the same during the entire time you pay it back. For instance, if you get a 4.5 percent loan, you pay interest on your balance at this rate until the loan is paid off or refinanced. The most common length for a fixed-rate loan is 30 years, though 15 year terms are also common. You can actually get fixed-rate loans from some lenders that run as short as 10 years, or as long as 40, or even 50 years.
Pros and Cons
A fixed-rate loan offers a predictable repayment schedule. You know your monthly payment from the time you get the loan. This makes it easier to budget, plus you avoid the risk of interest-rate fluctuations. If you lock in a low rate and rates go higher, you are in a favorable borrowing situation. A downside of fixed-rate loans is that if interest rates fall, you miss out. You can refinance to a lower rate, but this usually means refinancing your mortgage and paying additional loan costs.
An adjustable-rate mortgage, or ARM, has a fluctuating interest rate. When you get your loan, you have a period of time upfront with a fixed rate. Once that period is over, the lender resets the interest rate based on current market factors like the Federal Reserve's prime interest rate and the value of U.S. Treasury bills. Common ARMs are 3/1 and 5/1. The first number signifies the initial term in years of the fixed interest. The second number indicates the one-year terms of the rate resets. Seven- and 10-year fixed term ARMs are also available.
Pros and Cons
The initial interest rate on an ARM is regularly lower than the initial rate on a fixed-rate loan. An ARM also benefits you if rates are high when you get a mortgage, but they fall over time. Your loan rate remains low or drops as market rates drop. A drawback of adjustable-rate loans is the spike in your rate that usually occurs after the initial term. Homeowners tend to increase spending with increasing income and are sometimes unprepared for the jump in mortgage payments. Also, if interest rates rise over time, your mortgage rate goes higher.
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