A mortgage is a special type of loan for homebuyers.
In simple terms, the homebuyer will agree to hand over a certain percentage upfront in order to seal the deal with the lender. In return, the lender will pay the remaining balance, but it will eventually be paid back (plus interest).
There are a few different types of mortgage loans you can take out. The most popular options include a fixed-rate, adjustable-rate, and an adjustable-rate with interest-only payments.
Each type has its advantages and disadvantages. Ultimately it comes down to which one best supports your financial goals.
Here’s a more in-depth look at each…
Fixed-Rate Mortgage (FRM)
This is the most popular choice by far. When applying for a fixed rate, you are essentially agreeing to a mortgage where the interest rate stays the same throughout the life of the loan.
Most lenders will offer 10, 15, 20, or 30-year payoff periods. Shorter-term loans will result in higher monthly payments. But you will end up paying less in interest.
Fixed-rate mortgages offer stability and uniformity. The interest rate is locked in for the entire loan term, regardless of changes in the economy.
You will know exactly how much your monthly mortgage payments will be for the 10-30 years. This allows for long-term financial planning.
A locked-in interest rate can also be viewed as a negative.
Interest rates are constantly fluctuating alongside the performance of the broader economy. You could commit to an interest rate at 4%, and they very well could fall below that threshold over the life of the loan. You could always refinance, but that will involve repaying closing costs and possibly extending the loan term.
Fixed-rate loans generally have a higher interest rate compared to an adjustable-rate mortgage. But the price paid for stability may be well worth it.
Adjustable-Rate Mortgage (ARM)
This type of mortgage loan comes with an interest rate that varies over the life of the loan.
There will be an initial fixed-rate period, which could last anywhere from 3-10 years. After that, the rate will fluctuate yearly or even monthly, depending on the national benchmark.
ARM loans are typically offered at a lower interest rate, while the fixed-rate period is in effect.
There is more risk involved with an adjustable-rate mortgage.
After the fixed-rate period, your interest rate could be higher or lower on a month-to-month basis. This will affect your monthly mortgage payments and may hinder long-term financial planning.
On the bright side, ARM loans usually have a cap as to how much the rate can increase or decrease.
Adjustable-Rate, Interest-Only Mortgage
This type of loan allows the borrower to only pay the accrued interest on the loan for a certain period of time. This is called the interest-only period.
The length of this interest-only period will vary with each mortgage. It can last anywhere from a few months to many years.
After this period, the loan will transition to a standard ARM loan. Here’s the catch – the mortgage will still be expected to be paid off by the end of the original timeframe.
For example, if you had a 10-year, interest-only period on a 30-year loan, you would still need to pay off the entire loan in the next 20 years.
During the no-interest period, your monthly payments should be significantly lower. This can free up your financials for other things.
After the interest-only period, you will see your monthly payments go up substantially. This can be quite shocking. Not to mention, you will have less time to pay off the principal loan.
Which option is best?
That all depends on the homebuyer. It’s best to consider what you can afford and how long you expect to stay in the house.
For long-term homeowners, a fixed-rate mortgage is an excellent choice. Your interest rate will remain consistent and unchanged, even if rates spike up during your loan term.
Adjustable-rate mortgages entail more risk but may be worth it if the home is a temporary, short-term purchase. This is a good option if you plan to own the house only during the fixed-rate period and want to pay less in interest during that time.
Interest-only mortgages are the rarest by far. They’re better for borrowers who want to free up their money, possibly for other investments. You should be confident you can pay the higher payments once that initial perk ends.