Fixed-Rate
Loans
A
fixed-rate mortgage is so called because its interest rate doesn't
change over the life of the loan, no matter what rates do on the
open market. Many people feel more comfortable with a fixed rate,
because they know their monthly mortgage payments will remain steady
over the years, making at least one aspect of their monthly cash
flow predictable. The downside is that you pay for that comfort:
Lenders charge a higher rate of interest for fixed-rate loans. Why?
Because they figure that if interest rates shoot up, they lose the
opportunity to make more money on the funds they are lending you.
The
standard fixed loan lasts for 30 years, but if you can handle higher
payments and want to build up your equity in your home faster, you
can opt for a 15-year fixed. With a 15-year, you'll get a lower
rate and pay much less interest over the life of the loan. The payments
each month, however, will be quite a bit higher since they aren't
being stretched over so long a period.
Here's
an example: If you get a $125,000 loan with a 30-year fixed rate
of 7.75%, you'd be on the hook for monthly payments of $895.52.
On a 15-year version of the same loan, you might get a rate of 7.25%,
but your monthly payment would be $1,141. If you were cash-short
and wary of higher monthly payments, you'd go with the 30-year loan.
But ultimately it would cost you: On the 30-year loan you pay a
total of $197,386 in interest over the life of the loan, while the
15-year mortgage sticks you for only $80,394.
A
fixed rate makes the most sense for those who plan to stay put in
their new home for a long time. You pay a little more in interest,
but it is stretched over a longer period so the monthly effect can
be minimal. And if you're buying when rates are low, locking in
a good deal is probably worth it.
Adjustable-Rate
Loans
Adjustable-rate
loans get their name because the rate you pay changes according
to a set formula as interest rates fluctuate on the open market.
As noted above, the upside is that lenders charge a lower rate for
such loans because you are taking on some of the interest-rate risk.
This makes your monthly payments lower -- at least in the beginning.
Such loans provide a way for many buyers to afford a larger loan
amount for a given monthly payment. An adjustable works out wonderfully
if rates drop -- something you should never count on. But watch
out if interest rates rise. In a year or two, your payments could
far exceed what you would have paid for a 30-year fixed.
The
trick with adjustables is to tailor the loan to your needs. Generally,
the cheapest rate out there is on a one-year adjustable. (Well,
yes, there are even cheaper loans that adjust monthly, but those
are too esoteric for most buyers.) With a one-year, your rate can
change annually, making these loans particularly risky. Lenders
often try to draw you in with "teaser" rates that are
especially cheap for the first year, but which will almost certainly
jump up the next year.
There
is a limit to how much an adjustable can adjust, however. Lenders
limit the amount the rate can rise, often to no more than two points
a year, with a lifetime cap of six points. Moreover, if you are
willing to endure the hassle and expense of refinancing after a
year, it's possible you'll come out ahead.
A
slightly more expensive option is what's known as a "delayed
adjustable." When you see "3-1 adjustable" or "5-1
adjustable" it means that the loan stays fixed for three or
five years and then resets annually. The same pattern holds for
a 7-1 or a 10-1. The longer the fixed period, the higher the rate.
The idea is to match the loan to the amount of time you plan to
stay in the house. For instance, if you expect to move after three
years, a 3-1 is a great option. After 10 years, you might as well
opt for a fixed rate. The price difference will be minimal.
Figuring
out which kind of loan makes sense for you depends entirely on your
circumstances and temperament. Finding the Right Loan For You walks
you through some typical home buying scenarios and suggests mortgage
solutions.
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