It’s easier to settle into your new home if you’re confident you can afford it. That requires that you understand your mortgage financing options and choose the loan that best suits your income and ability to tolerate risk.
The most important features of your mortgage loan are its term and interest rate. Mortgages typically come in 15-, 20-, 30- or 40-year lengths. The longer the term, the lower your monthly payment. However, the tradeoff for a lower payment is that the longer the life of your loan, the more interest you’ll pay.
Mortgage interest rates generally come in two flavors: fixed and adjustable. A fixed-rate allows you to lock in your interest rate for the entire mortgage term. That’s attractive if you’re risk-averse, on a fixed income, or when interest rates are low.
An adjustable-rate mortgage does just what its name implies: Its interest rate adjusts at a future date listed in the loan documents. It moves up and down according to a particular financial market index, such as Treasury bills. A 3/1 ARM will have the same interest rate for three years and then adjust every year after that; likewise, a 5/1 ARM remains unchanged until the five-year mark. Typically, ARMs include a cap on how much the interest rate can increase, such as 3% at each adjustment, or 5% over the life of the loan.
Why agree to such uncertainty? ARMs can be a good choice if you expect your income to grow significantly in the coming years. The interest rate on some -but not all- ARMs can even drop if the benchmark to which they’re tied also dips. ARMs also often offer a lower interest rate than fixed-rate mortgages during the first few years of the mortgage, which means big savings for you-even if there’s only a half-point difference.
But if rates go up, your ARM payment will jump dramatically, so before you choose an ARM, answer these questions:
If you’ve saved less than the ideal downpayment of 20%, or your credit score isn’t high enough for you to qualify for a fixed-rate or ARM with a conventional lender, consider a government-backed loan from the Federal Housing Administration (FHA) or Department of Veterans Affairs (VA).
FHA offers adjustable and fixed-rate loans at reduced interest rates and with as little as 3.5% down and VA offers no-money-down loans. FHA and VA also let you use cash gifts from family members.
Before you decide on any mortgage, remember that slight variations in interest rates, loan amounts, and terms can significantly affect your monthly payment. Use our mortgage tools to determine how much your monthly payment will be with various terms and loan amounts.