Buying and financing a home is one of the biggest financial decisions you are likely to make in your lifetime. It can be especially overwhelming if it is the first time you’re buying and financing a home.
(It’s still a little overwhelming even if it’s the fifth time you’re buying and financing a home.)
The same overwhelm can set in if you are refinancing a home in the New Year.
While there is a no one-size-fits-all option when it comes to choosing a mortgage, knowing all of the options that are available to you and taking a look at the pros and cons can help you narrow down the best options for you.
Adjustable-rate mortgages (ARMs) have an interest rate that can fluctuate up or down over the life of the loan. Generally, adjustable-rate mortgages have lower interest rates than fixed-rate mortgages, but this is not always the case.
During periods when we have experienced record-low interest rates, there have been times when adjustable rate mortgage interest rates and fixed rate mortgage rates are the same or close.
The adjustment period for the mortgage can vary from loan to loan, but some adjustable rate mortgages adjust monthly and others adjust annually.
The biggest pro to having an adjustable rate mortgage occurs when interest rates drop. When interest rates drop, your adjustable rate mortgage adjusts, and you end up paying less as a monthly mortgage payment.
Because adjustable rate mortgages tend to have lower interest rates starting out than fixed rate mortgages, another advantage is that you start out with lower payments than you would with a fixed rate mortgage.
One of the biggest cons of establishing an adjustable rate mortgage is when the interest rates increase, your adjustable rate mortgage adjusts up, and you end up paying more as a monthly mortgage payment.
Even though you start out with lower monthly mortgage payments using an adjustable rate mortgage, it puts you at risk for an increasing mortgage payment, if and when rates increase.
Another disadvantage is that you don’t know what your fixed monthly mortgage payment is going to be over the life of the loan. This can be overwhelming to track and adjust to on a regular basis, which is why some homeowners opt to have a fixed rate mortgage instead of an adjustable rate mortgage.
Fixed-rate mortgages (FRMs) have a fixed interest rate for the life of the loan. Two of the most popular types of fixed-rate mortgages are the 15-year-fixed and the 30-year-fixed-rate. For individuals that like to know what their interest rate and monthly mortgage payment is, fixed rate loans offer this safety and security.
The biggest advantage of a fixed-rate mortgage is that your monthly mortgage payment does not change as interest rates increase. Another advantage to these types of mortgages is that it’s easy to understand how it works, which makes it a popular option for first-time homebuyers.
One of the biggest disadvantages of a fixed-rate mortgage is that your monthly mortgage payment doesn’t decrease if interest rates drop. Another disadvantage is that fixed-rate mortgages tend to cost you more money than an adjustable rate mortgage over time because the interest rates tend to be higher than ARMs.
Since you won’t benefit from a declining interest rate environment, you would have to refinance to benefit from a lower interest rate, which can be an expensive route to take because closing costs and other fees can be expensive.
The Federal Housing Authority (FHA) offers homebuyers FHA loans. These types of mortgages are guaranteed and backed by the federal government.
The primary benefit of an FHA mortgage is that the interest rates are typically lower than standard mortgage programs (those not backed by the federal government).
Another advantage of these programs is that the upfront costs for establishing the mortgage are low compared to regular programs.
For example, FHA loans can require as little as 3% of the purchase price of the home as a cash down payment, allowing a buyer to finance the other 97% of the purchase price of the home.
One of the biggest barriers to obtaining an FHA mortgage is the FHA has very stringent criteria borrowers have to meet to qualify for the mortgage. FHA mortgages also have a cap on the maximum amount of the mortgage that you can establish, so if your mortgage amount exceeds the cap, you wouldn’t be eligible for an FHA loan.
When your mortgage amount exceeds the FHA cap or you cannot qualify for a FHA loan, then you have to establish what is referred to as a jumbo mortgage. It sort of means what it sounds like it means—it covers large mortgage amounts.
The biggest advantage to establishing a jumbo mortgage is that it allows you to finance the purchase of a more expensive home or for a larger loan amount than you would be able to finance otherwise.
Because the mortgage amount is jumbo, the risk for default is higher, and the interest rate is higher—all disadvantages to having to establish a jumbo mortgage.
How Do I Know Which Options is Right for Me?
Unfortunately, it is not a cut and dry answer. One-size-does-not-fit all when it comes to choosing a mortgage.
You’re really the only one that can answer that question.
- Want a lower interest rate upfront
- Are willing to take the risk that your payments might change (up or down)
- Can afford to pay the mortgage payment if it increases
Then, an adjustable rate mortgage might be for you.
- Sleep better at night knowing what you mortgage payment is
- Are not willing to take risk with your mortgage payment
- Live on a fixed income or like fixed costs
Then, a fixed-rate mortgage is likely more appropriate for you.
When you are financing the purchase of a home or refinancing an existing mortgage, several different mortgage options are available to you. Your personal feelings and financial situation can narrow down the options that are right for you. Now that you know what’s out there, it’s time to consider which best fits into your personal financial situation.
Which mortgage option sounds right for you?