Types of Mortgage Loans

If, you anticipate living in your home for many years, the interest rate may be the main factor for you. If you expect to keep the house for only a short period of time, the closing costs may be more important to you. If you want to have ended any mortgage debt by the time you are facing your children's college bills or your own retirement, you may wish to consider a shorter term loan such as a 15-year fixed-rate mortgage. If your own retirement is years away, you may be less inclined toward a shorter-term loan, preferring to extend payments over a longer period of time through taking on a 30-year mortgage loan.

How important to you is the certainty of a fixed mortgage payment each month? If you want to make sure your mortgage payment remains the same each month, then you'll want to focus on various fixed-rate loans. If you are comfortable with periodic changes to your mortgage interest rate, then you may be inclined to consider adjustable-rate mortgages.

With an adjustable-rate mortgage (ARM), the interest rate you pay is adjusted from time to time to keep it in line with changing market rates. This means that when interest rates go up, your monthly mortgage payments may go up as well. On the other hand, when interest rates go down, your monthly mortgage payments may also go down. ARMs are attractive because they may initially offer a lower interest rate than fixed-rate mortgages. Since the monthly payments on an ARM start out lower than those of a fixed-rate mortgage of the same amount, you can qualify for a larger loan. The chief drawback, of course, is that your monthly payments may increase when interest rates go up. The types of people who typically benefit from an ARM are those that are planning to move or refinance in the near future, people with a high likelihood of increasing their income in later years, and people who need lower initial interest rates on their mortgage to be able to buy a home. How much your payments can increase will depend on the terms of your mortgage.

Before applying for an ARM, be sure you know how high your monthly payments could go - the so-called "worst-case scenario." An ARM has two "caps" or limits on how large an interest rate increase is permitted: One cap sets the most that your interest rate can go up during each adjustment period and the other cap sets the maximum total amount of all interest adjustments over the life of the loan. The rates on an ARM usually change once or twice a year, and there is typically a lifetime rate cap (or limit) on both the amount of each individual rate adjustment and the total amount the rate can change over the whole term of the loan. For example, if your loan starts at 5 percent, has a 2 percent per-adjustment cap, and a lifetime adjustment cap of 4 percent, you know that your loan might go up to 7 percent the first time the rate changes. You also know that the rate can never go over 9 percent over the life of the loan (5 percent start plus 4 percent lifetime cap). Only you can determine if you would feel comfortable paying this interest rate sometime in the future.

Some ARMs offer a conversion feature, which allows you to convert from an adjustable-rate to a fixed-rate loan at only certain times during the life of your loan. Ask your lender about this feature when researching ARMs. One important thing to know when comparing ARMs is that the interest rate changes on an ARM are always tied to a financial index. A financial index is a published number or percentage, such as the average interest rate or yield on Treasury bills.

This article is excerpted from a publication of Fannie Mae. © Fannie Mae