With current interest rates at all-time lows, a fixed-rate mortgage is the most predominant type of loan used to secure a home by first-time homebuyers. Fixed mortgages are attractive to cautious homebuyers (especially in the current economy) due to the stability and security of a payment that will not increase during the life of the loan. By having a fixed mortgage rate, the borrower is assured that their payments for principal and interest will remain constant and are not subject to fluctuations due to inflation.
Fixed-rate loans are generally selected when mortgage rates are low. Under the fixed mortgage umbrella, there are several options designed to suit the specific borrowing needs of consumers. Most prevalent are the 30-year fixed mortgage and the 15-year fixed mortgage [see article "15-Year vs. 30-Year Fixed Mortgages"].
Other types of fixed mortgages include the bi-weekly mortgage (for which payments are made every two weeks) and the convertible mortgage (best suited if mortgage rates are likely to drop in the future, at which point the borrower can convert their loan to a fixed rate). The balloon mortgage allows homebuyers to make reduced payments of interest and principal during an initial period, after which the full amount of the loan is due (in a lump sum) or must be refinanced. The interest-only mortgage allows borrowers to make payments towards interest only during an initial period, after which they must start repaying the principal as well.
A variable-rate mortgage (also known as an adjustable-rate mortgage, or ARM) can be appealing because the initial mortgage rate is generally lower than comparable fixed-rate loans obtained during the same timeframe. During the initial phase (depending on the margin, cap, and term length) a variable mortgage can potentially save the borrower money. However, once that first phase is over, the mortgage rate will adjust periodically depending on market conditions, which may increase or decrease the monthly mortgage payments.
The mortgage rates for variable loans are adjusted based on predetermined indexes and set margins, established at the onset of the loan. Commonly used types of mortgage rate indexes include: Constant Maturity Treasury (CMT), Treasury Bill (T-Bill), 12-Month Treasury Average (MTA or MAT), and Certificate of Deposit Index (CODI). Typically, caps are also implemented to prevent enormous increases in the mortgage rates and payments.
FOR EXAMPLE: Let’s take a variable mortgage with an initial interest rate of 4.5%, a margin of 2.5%, and a lifetime cap of 5.0%. Let’s say the current applicable mortgage index is 8.0%. The mortgage rate on this loan would be 10.5% (because 8.0% index + 2.5% margin = 10.5% total). However, since there is a lifetime cap of 5.0%, the maximum mortgage rate that can be charged is actually 9.5% (because 4.5% + 5.0% = 9.5%).
Within the variable mortgage rate family are some relatively new types of loans geared towards the needs of homebuyers with varying financial statuses. The payment-option ARM is designed to provide borrowers with monthly payment alternatives to help accommodate fluctuating cash flow ― these include a minimum payment option and an interest-only option, among others. It is vital that you thoroughly understand these types of home loans in case you need to be prepared for a sudden payment increase (i.e. payment shock).
There are benefits and drawbacks to both fixed mortgage rates and variable mortgage rates [see article "ARMs vs. Fixed Mortgages"]. The key is to do your research and determine which type of loan works best for you.