When you start looking for your first mortgage you’ll be introduced to a whole slew of new terms and abbreviations: Conventional fixed, ARM, FHA and PMI. Get your bearings by Googling each term and checking here about mortgages in general. But, even if you know what each term means, you’ll still need to decide which type of loan is best for you.
Conventional Fixed Rate Mortgage
A conventional 30-year fixed rate mortgage gives you the reassurance of knowing the amount of your monthly mortgage payment for the next 360 months. However, because the bank takes on the interest rate risk, they will charge you is higher rate than on a same-sized Adjustable Rate Mortgage (ARM) and, therefore, your monthly payments will be higher. If you choose a 15-year fixed rate mortgage, the monthly payments will be higher yet, and you’ll qualify for a smaller loan. However, with a 15-year loan you will build equity faster, pay much less interest, and own your place free and clear in half the time. If you’re planning to retire at 40, and then go sail around the world, a 15-year fixed is for you. If you are in a very stable personal and career situation, then you might want to choose a 30-year fixed.
Adjustable Rate Mortgage (ARM)
With ARMs most of the interest rate risk is on you, so the bank gives the mortgage at a lower initial interest rate and lower monthly payment, which means that with an ARM you may even qualify for a little bit larger loan and maybe a little bit nicer place. So, why wouldn’t everyone choose an ARM? The key is in the word adjustable.
There are 3/1 or 5/1 or 7/1 or 10/1 ARMs, and depending on which option you choose the interest rate varies, with 3/1 rates the lowest. To understand how they work, let’s take a typical 5/1 ARM loan as an example. It starts with equal monthly payments for a period of 5 years. The catch is that after that initial 5-year fixed rate period, the loan resets annually to the then prevailing interest rates, which can be much higher. To mitigate the hit, ARMs come with both annual and lifetime caps on how much each rate hike can be. However, over time your mortgage payment can really shoot up, and your $1,000-a-month mortgage could easily become a $1,500-a-month mortgage, or a $2,000-a-month payment turn into a $3,000-a-month payment in a few short years.
For most people the default option is a conventional fixed rate loan, but there are situations when you should give ARMs a closer look:
1. Your career prospects are strong. You have a good job in a growing company and growing industry. You can handle the payments even if they hit the maximum cap, and your finances will be strong enough to be able to refinance, if rates move up. Using an ARM frees a little more cash for other expenses you’ll have starting out, and to boost your savings.
2. You might be moving within a few years. You are not fully committed to the state/city/neighborhood where you would be buying.
3. Your relationship status is open. If you find “the one,” get serious, and start a family, you’ll probably need to move up from your first condo to a bigger place before the rates reset.
And last, but not least…
4. Your risk tolerance is high. You never wake up at 3am to obsess about your finances. You don’t have nightmares about becoming a homeless person. You trust that you can deal with whatever happens.
Whatever your professional and personal situation, make sure you’ll cover all your options with your mortgage lender, so you can make an informed decision and choose a mortgage that is right for you.