When you finally make the decision to buy the home, it's tempting to just accept the first financing you are offered, so you can get into that dream home as soon as possible. Doing so, however, may be risky to your financial future. There are two common types of mortgages issued to home buyers. Knowing the key differences between the two will help ensure you end up with the loan that's right for your situation.
Fixed Rate Mortgage
A fixed rate mortgage is the simplest and most common type of mortgage. With this type of loan, the bank charges you a set rate of interest. That rate of interest stays the same for as long as you hold the mortgage. For instance, you may be offered a 30-year fixed mortgage at 4.75%. That means that for 30 years (should you choose to stay in the home that long), your interest rate will remain at 4.75%.
When you have a fixed rate mortgage, your payments will be the same, month after month. This can be a real advantage, since a payment of $800, for example, will feel like a lot less 10 years down the road than currently, thanks to inflation. With a fixed rate mortgage, you are protected against rising interest rates. If you get a mortgage when rates are down at 4%, it does not matter if average rates shoot up to 9% a year later – you're still paying the 4% interest you secured a year ago.
Adjustable Rate Mortgage
When you are granted an adjustable rate mortgage, you initially pay an interest rate that is below market value. If the average mortgage rate is 4%, for example, you may initially pay 3% interest on your adjustable rate mortgage. Over time, however, this interest rate increases in proportion to the market rate. You are told, when you sign up for the loan, how long you'll be paying the low, introductory rate – but you are not told what the rate might end up being after this introductory period.
Many people get themselves in trouble when they sign up for an adjustable rate mortgage. Once the rates increase, they struggle to pay the higher monthly payments. However, there are times when adjustable rate mortgages are a good choice. If you know you'll only be in a home for a short period of time and are sure you won't still be there when the higher rates kick in, then signing up for an adjustable rate mortgage may result in lower payments than a fixed rate mortgage.
This type of mortgage also allows customers to qualify for larger loans overall. This can be an advantage if you are applying for a mortgage as an individual, but have someone else who will be contributing to payments, and thus are able to afford a larger loan than your income would suggest.
For most home buyers, a fixed rate mortgage is the wiser choice, since the payments are easier to predict. However, you may be in a situation where an adjustable rate mortgage is a good choice. Talk to a financial advisor or real estate attorney for more personalized advice.