Choosing the Right Mortgage – Part 2

When the time comes to shop for a mortgage it’s important to consider all of your options carefully. In a previous post we talked about FHA and Conventional financing. This time we’ll explore the differences between fixed rate mortgages and adjustable rate mortgages (ARMs). Both FHA and Conventional financing offer fixed and adjustable rate mortgages.

Fixed-Rate Mortgage

With this type of loan, the interest rate remains the same for the life of the loan. Lenders generally offer Conventional fixed rate loan terms (i.e. the length of time) ranging from 10 to 40 years and FHA fixed rate terms of 15 or 30 years.

Generally, the shorter the term of your loan, the lower your interest rate is. So for a 15-year term while the rate is lower, it’s important to remember that the payment will be higher because you’re paying off the loan in a shorter amount of time.

Deciding on the term of a fixed rate loan requires careful thought before making a decision. While a 30-year loan offers a lower payment compared to a 15-year loan, many people like knowing they’ll pay less interest and build equity more quickly on a loan with a lower term.

A fixed rate loan offers numerous advantages including the comfort of knowing your mortgage payment will remain the same, which makes budgeting your finances much easier.

Adjustable Rate Mortgage (ARM)

An ARM does not have a fixed interest rate for the entire term of the loan; however, there is an “initial” or “introductory” period that ranges anywhere from 1 month to 10 years before the rate may change. Unlike the options available for fixed rate loans, most ARMs only have a term of 30 years.

One feature of an ARM is that the introductory rate is typically lower than the prevailing rate of a 30-year fixed loan. The name of an ARM program may give you an idea of how the loan works. For example, a “5/1 ARM” typically has an initial fixed rate for the first 5 years and then the rate (and therefore the payments) can adjust annually for the remaining 25 year term. Other popular ARM programs have introductory periods of 3, 7 or even 10 years before the first rate adjustment may occur.

Whether the rate changes after the initial period is based on several factors including the “Index”, “Margin” and “Caps”.

  • The Index is used as a baseline to determine how much an ARM rate could change at each adjustment. An example of a popular ARM index is the interest rate on US Treasury Bills.
  • Lenders then add a Margin on top of the Index to arrive at a Fully Indexed Rate.
  • Once adjustments start, the ARM rate for the next time period is usually close to the Fully Indexed Rate; however, there may be limits on how much the rate can adjust (up or down) based on caps. There could be periodic caps that limit how much the rate can change at each adjustment and/or lifetime caps that limit the maximum rate over the entire term.

It’s important to understand that the rate on an ARM may increase or decrease after the introductory period. You should review the details carefully to determine if you could still afford to make the payments if the rate were to increase to the maximum.

An ARM may be a smart decision if you only plan on living in a home for a few years and don’t need the “payment security” that a fixed rate loan offers. It may also be a good option if you want lower monthly payments during the first few years as you adjust to owning your new home.

When choosing a mortgage program, you should consider what monthly payment you would feel comfortable with and then speak to a lender to determine which programs you qualify for.  You should also think about future events that may impact your financial or personal situation such as changes in your income/employment, household size, educational expenses, etc.

With interest rates at historic low levels, either a fixed rate or adjustable rate can help you move into the Toll Brothers home of your dreams sooner than you thought possible.

To learn more about your financing options you should speak to an experienced home loan professional at TBI Mortgage® Company. For more information, please call them at 1-800-647-9735.

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