Fixed vs. Adjustable-Rate Mortgage Loans

If you are a first-time homebuyer, the process can be confusing. The documents are plentiful, and the process is lengthy, so there is no way to be completely prepared. But understanding a few basics before talking to financial institutions or loan officers, will give you an advantage.

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There are pros and cons to each type of mortgage, so let's start by examining the differences and how each type works.

Fixed-Rate Mortgages

Easy to understand, a fixed-rate mortgage provides the customer with a rate that will remain constant throughout the life of the loan. It allows the buyer to be able to count on a steady monthly payment, even though the amount that is paid toward interest and principal will vary throughout the entire period.

A larger portion of the interest is paid during the first few years of the loan and toward the end, the large portion goes toward the balance. This is because the institution makes sure a large part of the interest is paid before the house is resold, or the loan refinanced or anything else that might upset the expected profit. Take a look at a sample amortization schedule to better understand this.

But as a quick example: If the payment of $1,200 is made monthly and the interest is around 6%, the first payment will be split with $1,000 going toward interest and only $200 toward the principal (actual cost of the home).

Fixed rate mortgages are generally offered in terms of 15, 20 and 30 years. Of course, the term has everything to do with how much you are paying in total.

Adjustable-Rate Mortgages (ARM)

True to it's name, ARM loans have interest rates that change over time. They promise a specific rate for a certain period and then afterwards the rate can change. The shorter the adjustment period, the lower the initial interest rate.

Understanding ARM loans is more difficult than fixed-rate loans, but here are the highlights:

  • You will agree to how frequent the rate can change.
  • You will also agree to which index the rate will be tied to. For example2% of current Treasury bills, etc.
  • There will also be a ceiling on how high the interest rate can increase per period.
  • Caps on monthly payments make sure you are not put in a position of having a higher payment than you can afford.
  • The negative part of this is that if the payments don't cover the interest due, it is added to the principal. This means the principal can grow over timeunless you make sure you are paying enough over the requirement to pick up the slack.

ARMs are very attractive to those who are working hard to be able to afford the home, as the initial payments are typically lower than fixed-rate mortgage loans. They are also perfect for those periods when loan rates fall as refinancing is not necessary. The rate will drop along with the economic benchmarks.

Which Type of Mortgage Loan is For You

This is a very personal decision and one that should be measuredforeach or couple's financial situation. A few questions to ask yourself before you take the big step:

  1. What size mortgage payment is comfortable today and in one year?
  2. If interest rates rise, can you comfortably make higher than necessary payments to insure your principal does not increase?
  3. How long do you plan to own the property as a primary residence?
  4. Have you researched the last decade or two of interest rate history? Where are interest rates today? Where might they be in the next five yearsif cycles repeat themselves?

Select your loan terms carefully, and they will serve you rather than add stress while you live your American dream as a homeowner. It's meant to be an investment, not a burden.

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Posted in Financial Services Post Date 10/16/2020