There are two major types of mortgage loans: fixed-rate mortgages and adjustable-rate mortgages. If you are considering purchasing a home, you will need to understand the differences between these types of loans.
Fixed-Rate Mortgage Loans
Fixed-rate mortgages are the most predominant type of loan used to secure a home by new homebuyers. When interest rates are low, a cautious homebuyer may want the stability and security of monthly payments that will not increase over the life of the loan. By having a “fixed rate,” the borrower is assured that their payments for principal and interest will remain constant throughout the loan term because they are not subject to inflation. Most prevalent are the 15-Year Fixed-Rate Mortgage and the 30-Year Fixed-Rate Mortgage. Where interest rates are very low (as they are currently), a fixed mortgage is usually the safer choice.
Under the fixed-rate mortgage umbrella, there are several variations that are geared to suit specific borrowing needs. These include the Bi-Weekly Fixed-Rate Mortgage, where a borrower makes payments every 2 weeks (instead of once a month), thus reducing the loan term and the amount of interest they pay. The Convertible Mortgage is best suited for times when interest rates are high and likely to fall in the future, giving the borrower the option to convert his/her loan to a fixed mortgage when rates drop. The Balloon Mortgage allows borrowers to make reduced principal and interest payments for a finite period of time based on fixed mortgage schedule, after which the full loan balance must be paid in a lump sum or the loan must be refinanced. The Interest-Only Mortgage allows the borrower to make interest-only payments for a set period of time, after which the loan is restructured for interest and principal payments.
Adjustable-Rate Mortgage Loans
Adjustable-rate mortgages attract homebuyers because the initial mortgage rates are generally lower than the rates for comparable fixed mortgages. The interest rate on an adjustable mortgage fluctuates throughout the life of the loan, based on a particular economic index and a set margin ― both which are established at the onset of the loan. Types of economic indexes that are used for adjustable-rate mortgages include the Constant Maturity Treasury (CMT), Treasury Bill (T-Bill), 12-Month Treasury Average (MTA or MAT), and the Certificate of Deposit Index (CODI), among others.
Within the adjustable-rate mortgage family, there are some different types of loans suited for homebuyers with varying financial needs. One example is the Payment-Option Adjustable-Rate Mortgage, which is designed to provide borrowers with payment alternatives to accommodate fluctuating cash flow ― these include minimum payment options and interest-only options.
It is wise to thoroughly understand these types of mortgages, as you may need to be prepared for a sudden increase in your monthly payments (payment shock). Depending on the loan term, the margin, and the rate cap, an adjustable mortgage can potentially save the borrower money. However, adjustable-rate mortgages also carry much higher risks for borrowers than fixed-rate mortgages.