Just like how the amount of house you can afford depends on your financial situation and comfort level, the same applies to what kind of mortgage you should get. There are three main types of mortgage loans for homeowners; fixed-interest, adjustable rate, and interest only.
With a fixed-rate home loan, your interest rate remains the same for the life of the loan and the payment is split into equal monthly payments for the duration. Fixed-rate home loans can be 10 years, 15 years or 20 years, but the most popular are the 15 and 30-year terms.
15-Year: This loan is best for those individuals who like the security of fixed monthly payments and can afford the higher payments. The 15-year fixed-interest loan allows the homeowners to build equity quickly and pay less interest over the time of the loan. The main risk comes if your situation changes, causing you to have a difficult time paying the high mortgage payments. Along with this, the higher payments could impact your current financial goals of growing savings, college funds and saving for retirement.
30-Year: The 30-year fixed-rate loan is the most common. This seems to be the best type of loan for individuals who plan on staying in their home for more than 10 years. Although you incur more in interest with this loan, you will be able to take advantage of tax deductions on the interest and you are also able to pay more on the loan than just your monthly payments so you can pay the mortgage off sooner than 30 years. Just check with your lender to see if there are any penalties to making extra payments. The only risk occurs if rates fall dramatically. To take advantage of better rates you have to refinance, which costs money.
Adjustable-rate (ARMs) mortgages come in various forms. One example is a hybrid ARM, which features aspects of both adjustable and fixed-rate mortgages. These can be anything from a 3-year, 5-year, 7-year or 10-year fixed interest rate period.
When your initial rate period ends and your ARM is ready to adjust you may be paying more or less in mortgage payments depending on the current market. These loans are beneficial if you are planning on selling your home in a given time frame. Investors also like ARMs because the initial interest rate is lower thank fixed-rate loans, and instead of paying higher monthly mortgage payments, they can use that extra money to make other investments. ARMs are considered risky because you have no guarantee of future payments. They also come with more financial jargon than most people would care to know.
Interest-only loans are for buyers who need rock-bottom payments for several years. With this loan, the homeowners are allowed to pay only interest for the first few years, with the most common term being 5-year fixed 30-year. This payment option would make sense for people who expect their financial situation to dramatically change in the near future. An example would be with high-income professions such as law and medicine, along with parents who have children graduating from college and no longer are make large financial contributions towards their education.
The risk for this mortgage option is if your house does not appreciate as you expected, your refinancing options could be limited when your interest-only period ends. If you don’t refinance you could be stuck with very high mortgage payments.