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Fixed-rate and Adjustable rate are two main types of mortgages.
Fixed Rate Mortgages
In Fixed rate loans you pay the same interest rate for the
entire term of the loan. Generally most fixed rate mortgage
loans are for 30 years, although they are available for 15
or 20 years.
Shorter loans such as 15 or 20 year mortgages usually carry
lower interest rates, typically one-half or one-quarter of
a percent lower than a 30 year loan. But the total monthly
payment will be higher than that of a long-term loan,
since it involves making larger payments in order to pay the
loan off in the shorter time period.
With a short-term loan you will pay less overall, than
if you'd borrowed the same amount with a longer loan. Depending
on your circumstances, it may be beneficial to consider a
shorter loan. You have to make lower monthly payments in a
longer loan, but if you can afford the higher payment, you
may save a lot of money in the long run if you take a shorter
loan, and build equity much faster.
Adjustable Rate Mortgages
The second main type of loans available is Adjustable-rate
mortgages (ARMs). With an ARM, your interest rate, and therefore
your payment, can increase or decrease through the life of
the mortgage, depending on various economic factors.
The interest rate is usually tied to a money market index,
most commonly the one-year Treasury bill. The mortgage lender
will usually add between two and four percentage points to
the current rate for the Treasury bill to come up with your
current adjustable rate. These extra percentage points are
called the margin.
The ARM mortgage rate usually begins lower than the fixed-rate
mortgages available at the same time, sometimes by as much
as two percentage points. This mainly depends on the economic
situation at the time. The terms of the loan specify the rate
adjustments, when they begin and how often they occur.
The first rate change can take place anytime from after one
month to ten years, but one year is the most common. If rates
drop, your payment could decrease, but if they rise, your
payment will increase.
ARMs do usually have a cap, which states the maximum
amount a rate can change at one time. The cap also
states the maximum amount it can vary from the original rate
over the term of the loan. A few ARMs also come with a payment
cap, which states the maximum amount the payment can go
up over the life of the loan. This is not stated in percentage
rates but in dollars.
Some ARMs also include a clause called a conversion option.
This option allows you to convert the adjustable rate mortgage
to a fixed rate mortgage at some point in the future for a
set fee. It is good to consider this option in case interest
rates begin to rise.
Pros and Cons of Fixed Rate Mortgages
The main advantage of a fixed-rate mortgage is that your
payment remains fixed through the term of the loan. This type
of mortgage is easy to comprehend and makes planning easier.
However, if want to take advantage of dropping interest rates,
you would have to refinance, which involves extra paperwork
and costs. Also, if mortgage interest rates are high, it will
prove to be expensive since there are no initial rate cuts.
Finally, fixed-rate mortgages are pretty standard from lender
to lender, which means you do not have much scope to negotiate
the terms of the loan to suit your requirements.
Pros and Cons of Adjustable-Rate Mortgages
ARMs, permits you to take a bigger mortgage. If you know
your income will be increasing in the future or that you will
be selling the house in less than five years, ARMs will benefit
you. Also, if rates begin to fall, it will not be necessary
to refinance in order to lower your payments, they will be
automatically reduced to the new, lower rates.
However, with an ARM, your payment and interest rate can go
up substantially during the life of the loan, even with caps
in place. The initial rates are usually lower than market
rates, so when you receive your first rate adjustment, it
can be quite a change, especially since the caps don't always
apply to the first adjustment.
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