Fortunately for buyers, there are a variety
of mortgages to choose from. It is in your best interest to
investigate each of them to determine which is the best for
your situation. You probably won't qualify for all of them.
In fact, you may only qualify for one. But if you do qualify
for more than one, you may save yourself money (and worry)
in the long run if you do your homework before signing on
the dotted line.
Fixed Rate Mortgages
Consider a fixed rate mortgage if either of the following
- You plan on living in your new home
for many years, and/or
- You are not a risk-taker and prefer
the stability of knowing how much your payment will be each
Since most home loans are for a period of 30 years, if you want a payment you can count on for that long of a period of time, a fixed rate mortgage may be what works best for you. Once your loan amount and interest rate are calculated and locked in, a fixed rate mortgage will guarantee that you will have the same payment over the life of the loan. Making extra payments to principal will allow you to pay your loan off sooner.
This may not always be the best choice, however. If interest rates are very high at the time you take out your loan, with a fixed rate mortgage you'll be stuck with that high interest for the life of the loan (unless you choose to refinance). Conversely, if interest rates are very low, you'll come out the winner with interest rates that will stay low no matter how high interest rates go in the future.
The following are descriptions of the varying lengths and terms of fixed-rate mortgages:
- You to pay off the loan in half the
time of a 30-year loan.
- Equity builds up more quickly than
in a 30-year loan.
- Payments are higher (which
may be a problem if you lose your job or become unable to
- You to pay off the loan in 2/3 the
time of a 30-year loan.
- The overall interest paid is considerably
less than for a 30-year loan.
- The most common choice, especially
for first-time homebuyers, as it's the easiest of the fixed-rate
loans to qualify for.
- Monthly payments are lower than for
15-year and 20-year loans. This can prove especially helpful
if you don't have a lot of "padding" between the
amount you can afford to spend & the monthly payment
for your desired property.
- More desirable if you plan on staying
in the same home for years, since equity builds more slowly
than for shorter-term loans.
- For income tax purposes, this term
provides the maximum interest deduction.
If you are more comfortable in taking a risk with your money or if interest rates are very high, or falling, at the time you take out your loan, an adjustable-rate mortgage (ARM) may be the solution for you. You might also choose this type of loan if your planned ownership of the property is short-term or if you expect your income to increase to cover any potential rise in the interest rate.
Generally, the interest rate when you take out your loan will be lower than a fixed-rate mortgage. Please note that this is true initially, not necessarily long-term.
Since an ARM rate rises and falls depending on the prevailing interest rate, your mortgage payment will rise and fall accordingly. If your income isn't sufficient to cover the highest possible payments, then this option isn't for you. On the positive side, the lower initial payments will allow you to qualify for a larger loan than if you choose a fixed-rate. The downside is that your payments will increase if/when the rates go up.
Typically, ARM interest rates are tied to a specific financial index (such as Certificate of Deposit index, Treasury or T-Bill rate, Cost of Funds-Indexed Arms or COFi, or LIBOR [London Interbank Overnight Rate]) and your payment will be based on the index your lender uses plus a margin, generally of two to three points. Get the formula used by your lender in writing and make sure you understand what it means.
Fortunately, the amount an ARM can increase is not unlimited. There are "caps" on how much your lender can increase your rate, both for a period of one year and for the life of the loan. Plan ahead, and have your lender calculate what the maximum payment would be if your rate went to the highest amount allowed by the cap for your particular mortgage. If you're not confident you'll be able to pay that amount on a monthly basis, perhaps you should reconsider this type of loan.
If neither the fixed-rate nor the adjustable-rate mortgage seems the best option, perhaps the convertible ARM will be right for you. This alternative combines the initial advantage of an ARM with a fixed rate after a predetermined number of years. Obviously, this type of mortgage has more advantages when the initial interest rate is low and the future rate is not guaranteed.
Interest Only - I/O Loans
Interest only loans have become popular in recent years. All you pay is the interest on the money borrowed. In this case the entire payment will qualify for a tax deduction. Since you are not paying down the principle more of your payment is applied toward interest and, therefore, you can borrow more. In a "hot" real estate market this can help you buy the home you might otherwise not be able to afford. But there are pitfalls. Remember that someday you will have to pay the principle. You are betting, of course, that the home will appreciate and that when you sell you will have enough, after closing costs and commissions, to pay off the principle. If the value of the house does not rise, however, you will still need to pay the bank the principle and you could be left "upside down," owing more than the home is worth. Approach I/O loans with care and get good financial advice.
Another mortgage option available to some people is a government
loan, providing that you meet the qualifications for these
- VA Loans: Veterans
may qualify for a loan from the Veterans
Administration. There is a limit on the amount you can borrow,
so this option works best for those buying a lower priced
- FHA Loans:
The Federal Housing Association offers loans to lower-income
Americans. Look for the phrase "FHA approved" when looking at ads for homes.
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