The two most common types of loans are fixed-rate mortgages and adjustable-rate mortgages, known as ARMs.
A fixed-rated mortgage comes with an interest rate that remains the same for the duration of the loan.
The life or term of a mortgage is 30 years by industry standards, but 10, 15 and 20-year term loans are also available.
Shorter term loans usually come with cheaper interest rates. A 15-year mortgage's interest rate is often one-quarter to one-half percent lower than a 30-year mortgage. Both the cheaper rate and the shorter term mean you'll also pay less interest over the life of the loan than you would if you borrowed the same amount of money with a long term loan.
Monthly payments of a shorter term loan, however, are generally higher than the same loan for a long term because the larger payments of the short term loan are necessary to repay the debt sooner.
A long term loan with smaller monthly payments can be easier to budget, but if you have a stable salary that allows you to afford the larger monthly payments, the shorter term loan could be advantageous.
Fixed rate mortgages protect you from the risk of rising interest rates and higher payments. Of course, since you are locked in to a given rate, you could end up with a rate higher than the going rate should interest rates fall.
The second most common mortgage is an ARM. The interest rates can adjust up or down, depending upon current economic trends.
An ARM's rate is based on a money market index. The one-year U.S. Treasury bill is often used because it's yield is similar to the 30-year U.S. Treasury bill used to set rates on 30-year fixed mortgages. ARMs might also be tied to other indexes, including certificates of deposit (CDs) or the London Inter-Bank Offer Rate (LIBOR) rates, among other regularly published indexes.
To come up with the ARM rate, lenders add a "margin," usually two to four percentage points, to the index.
Initially, the ARM rate is lower than the fixed rate, from about a quarter point to two points or more, depending upon the economy. When the first adjustment occurs (from six months to many years) and how often the rate adjusts, depends upon the terms of the mortgage. After the first adjustment occurs, subsequent adjustments can occur every month, six months, once a year, or during longer periods. The adjustment period is disclosed in the terms of the mortgage.
ARMs typically have limits or "caps" on how high it can adjust during each adjustment period as well as over the life of the loan.
The caps protect you from fast market changes, but ARMS don't offer the stability of a fixed rate loan.
ARMs' lower initial rate, however, can help you qualify for a larger home or start you off with smaller payments than you'd have to pay for the same mortgage with a higher fixed rate. And if index rates fall with an ARM, so does your monthly mortgage.
ARMs could also be a good choice for someone who knows their income will rise and at least keep pace with the loan rate's periodic adjustment cap. If you are planning to move in a few years and are not concerned about the possibility of a higher rate, an ARM also could be a good choice. |
