Choosing the Right Mortgage
A mortgage is a serious long-term financial commitment and a legally binding contract. Selecting the right mortgage may make a big difference in your monthly payments and the overall cost of your loan.
Choosing the right mortgage means doing your homework about the different types and understanding how each one may change your monthly payments in the future. To ensure that you obtain the mortgage that is right for you and meets your financial goals, it is important that you understand the differences between types of mortgages by talking with reputable credit counselors and lenders.
There are two main types of mortgages – fixed-rate and adjustable rate – that have their own set of features and benefits that need to be carefully considered.
Fixed-rate mortgages are the most common type of mortgage selected by homeowners today. With a fixed-rate mortgage, you are locked in to a set interest rate, resulting in monthly mortgage payments that remain the same for the entire term of the loan, whether it's a 15-, 20- or 30-year loan.
The primary benefit of fixed-rate mortgages is inflation protection – meaning that if mortgage rates increase in the future, your mortgage rate will not change.
Things you may want to consider with a fixed-rate mortgage:
- Your interest rate won't go down, even if rates drop. Your rate is locked in and will remain the same for the duration of your term – even if rates decline. However, you can consider
refinancing your mortgage if rates drop to a level where it makes financial sense to do so.
- Your payment can increase based on changes to your taxes and insurance. Your mortgage payment is comprised of principal, interest, taxes and insurance. While your principal and interest payment (typically the bulk of the payment) will not change over the life of your loan, your taxes and insurance may increase, resulting in changes to your monthly payment.
When selecting the term of a fixed-rate mortgage, it is important to understand the features and benefits of each. Most mortgage lenders offer at least two basic terms: 15 and 30 years, and many also offer 20-year fixed-rate mortgages.
- 30-Year Term. With this term, your monthly payment will be lower due to the extended period of the loan, but your interest rate is typically higher and you pay more interest over time.
- 15-Year Term. This term has higher monthly payments because the loan term is significantly shorter; however, you can build equity much faster than with a 30-year fixed-rate mortgage, and pay less interest over the life of your loan. Interest rates are typically lower for this term.
To determine the best term for your personal situation and one that aligns with your financial goals, talk with your lender or financial professional for guidance. Also, take a look at our calculators to see how changes to terms and interest rates can affect your monthly payment.
An adjustable-rate mortgage (ARM) is a loan with an interest rate that will change throughout the life of the loan. An ARM may start out with lower monthly payments than fixed-rate mortgages, but you should know that:
- Your monthly payments may go up over time and you will need to be financially prepared for the adjustments.
- Monthly payments can go up, even if interest rates do not increase.
- Your payments may not go down much, or at all, even if interest rates drop.
- You might incur a penalty if you try to pay off the loan early in the hope of avoiding higher payments.
All ARMs have adjustment periods that determine when and how often the interest rate can change. There is an initial period during which the interest rate doesn't change – this period can range from as little as 6 months to as long as 10 years. After the initial period, most ARMs adjust.
The most common ARMs are 3-, 5-, and 7-year ARMs. To help you understand how ARMs work, consider the following example:
- A 3/1 ARM has a fixed interest rate for the first three years. After three years, the rate can change once every year for the remaining life of the loan. The same principle applies for a 5/1 and 7/1 ARM. If the rates increase, your monthly payments will increase; however, if rates go down, your payments may not decrease, depending upon your initial interest rate.
Most ARMs also typically feature an adjustment “cap” which limits how much the interest rate can go up or down at each adjustment period. For instance:
- A 7/1 ARM with a 5/2/5 cap structure means that for the first seven years the rate is unchanged, but on the eighth year your rate can increase by a maximum of 5 percentage points (the first "5") above the initial interest rate. Every year thereafter, your rate can adjust a maximum of 2 percentage points (the second number, "2"), but your interest rate can never increase more than 5 percentage points (the last number, "5") throughout the life of the loan.
When considering an ARM, ask yourself:
- If the mortgage rate increases, can I afford a higher mortgage payment? Use our calculator to estimate how a higher mortgage rate can impact your mortgage payment.
- Do I plan to live in my home for less than five to seven years – or less than the adjustment period? If yes, this mortgage may be right for you.
You may also want to look at mortgage rate trends by following Freddie Mac’s weekly Primary Mortgage Market Survey (PMMS). While no one knows for certain what mortgage rates are likely to do in the future, it is worth understanding why they move and how they have moved recently when considering an ARM.
To determine the best type and structure ARM for your situation, talk to you lender or financial professional for guidance. Be sure you know the details of how and when this type of loan may change your monthly payments.
Tools and Resources
- CreditSmart® Online Training
- Mortgage Rates Hit 50-Year Low
- Buying a Home
- Choosing the Mortgage Option for You
- Step-by-Step Mortgage Guide
- Roles and Responsibilities
- Glossary of Terms
- Tax Savings Calculator
- How Much Can You Afford Calculator
- Fixed or Adjustable Mortgage Calculator
- More Calculators
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