Evaluating Mortgage Types

Finding a mortgage can be a stressful process. Not only are there hundreds of institutions offering mortgages, but it can also seem like there are dozens of different types of mortgages. Varying interest rates, lengths, and other features can be confusing. This article explains some of the options you might encounter while shopping for a mortgage. As you consider your choices, remember two things:

• How long do you expect to live in the home?
• What is your tolerance for monthly payments increasing?

Fixed Rate Mortgages

As the name suggests, a fixed-rate mortgage has an interest rate that is set when you take out the loan and stays the same throughout the mortgage’s duration. The monthly payment also remains steady. Knowing your payment amount can provide peace of mind.

Each monthly payment consists of interest and principal, with early payments mainly covering interest and payments toward the end of the mortgage mostly reducing principal. Most of the mortgage payoff occurs late in the term.

Most institutions offer fixed-rate mortgages of 15 and 30 years. The advantage of the shorter 15-year mortgage is that, after 15 years, you will have paid off the loan and own your home outright. You will also pay less interest over the life of the loan. The downside is that your monthly payments will be higher.

Choosing the term of a fixed rate mortgage is usually a function of what level of monthly payments you can afford and how anxious you are to pay off the entire mortgage.

Adjustable-Rate Mortgages (ARMs)

With an adjustable-rate mortgage, the interest rate and monthly payments can change as interest rates fluctuate. The rate is fixed at first and can be reset based on changes in a certain interest rate benchmark. The main advantage for the borrower is that ARMs usually start with interest rates that are lower than those of fixed-rate mortgages. Sometimes, the difference can even be 1½ to 2½ percentage points less.

There are several features of ARMs that you should evaluate if you are considering this type of mortgage.

1. Initial rate. Be careful if the initial rate seems really low. It could be a "teaser" rate that only lasts for a short time, and then the rate is adjusted upward. At a minimum, ask what the rate would be adjusted to if the initial rate ended today.
2. Benchmark the ARM is pegged to. ARM rates are usually tied to some "published" index that reflects the general interest rate market. Typically, the ARM rate is set at the benchmark plus a margin. Ask the lender how this works and understand how the benchmark rate has changed recently.
3. The cap. Most ARMs have limits on how much the rate can increase in one year, and some also have a cap on the maximum rate over the mortgage’s duration. Knowing how the caps work will help you understand "how bad it can get" if rates rise significantly.
4. Length of the rate periods. When you look at ARMs, you may see terms such as 10/1, 7/1, 4/1, and the like. These refer to how long the initial rate lasts and how often it is adjusted thereafter.

Adjustable-rate mortgages appeal because of their lower initial rates. Your risk is that your rate and monthly payment might increase in the future. If you’re comfortable accepting a higher payment or expect to move soon, the savings with an ARM can be significant.

Other Issues

Negative amortization. This is the process of paying off a mortgage. Some lenders offer loans with lower monthly payments than the interest due, which means the balance increases over time. Avoid this type of mortgage.

Balloon mortgages. Balloon mortgages are similar to fixed-rate mortgages with consistent monthly payments using a 15 or 30 year amortization schedule. However, with a balloon, the loan becomes due before the full 15 or 30 years. Most balloon mortgages last for 3 to 7 years. They typically offer lower interest rates than traditional 15 or 30 year fixed-rate mortgages. But remember, with a balloon, your mortgage will be due on a specific date, and you’ll need to take action.