Finding the perfect house typically proves the easiest step in the path to homeownership. Choosing the right mortgage rates as the most critical decision, as you determine how much interest your choice of mortgage will cost you, depending on the length of the mortgage and whether you choose a fixed- or variable-rate mortgage.
When you take out a mortgage to purchase a home, your lender will require that you repay the loan principal, plus interest, on a fixed schedule of payments. The amount of interest accrued on the loan depends primarily on the length of the mortgage, the interest rate your lender charges and whether you take out a fixed-rate or variable-rate mortgage, also known as an adjustable-rate mortgage or ARM. With a fixed-rate mortgage, your interest rate does not change. With an ARM, your interest rate can change frequently and substantially over the life of the loan.
How They Work
The Federal Reserve Board defines ARMs as mortgages with a fixed interest rate for a set period of time, after which your interest rate may change many times. Lenders may set the initial fixed-rate term at one month to 10 years, with interest-rate adjustments occurring each month, quarter, year or more. A 5/1 ARM, for instance, uses a five-year fixed-rate period, with the interest rate subject to change every year thereafter. Most ARMs have a limit or cap on how high or low the interest rate may fluctuate at any given time.
Types of ARMs
Typical ARMs, known as amortizing-payment ARMs, have payments much like a fixed-rate mortgage, where a portion of each payment goes toward the original loan balance and the rest toward principal. While structured similarly, an accelerated amortizing payment ARM offers a much shorter length of the loan -- usually 15 years or less. An interest-only ARM features an initial deferment of principal payments, resulting in lower payments that satisfy only the accrued interest, for a set period of time. The riskiest type of ARM, the minimum-payment ARM, serves as a variation on the interest-only ARM. It defers principal payments and the lender doesn't require you to pay all of the interest as it accrues. The lender then adds the unpaid interest to your original loan balance until the deferment period ends and you begin regular principal and interest payments.
Variable-rate mortgages mean more risk for you and less risk for the lender, so lenders try to make these more attractive through lower initial interest rates and fewer fees. Option ARMs rate as the riskiest option, with Bloomberg Businessweek dubbing them “nightmare mortgages.” If you're not planning on staying in your new home past the initial fixed-rate term of the mortgage, however, a variable-rate mortgage could be your best choice.
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