Financial Planning, Millennials

Understanding The Different Mortgage Options: Fixed, Variable, ARM’s, and Interest Only

Welcome back!

We are continuing on with this series about home buying. Over the past two weeks, we talked about:

Both of these posts blew up and I got a ton of questions about what ARM’s are, if you should buy down points, etc. So we will talk about all of that in today’s post.

For the past 5 years, pretty much everyone would take a 15 or 30 year fixed mortgage. Rates were so low you would be dumb to not lock that rate in. However, things are a little different today. Rates have gone up extremely fast.

Because of this, it makes sense to view all your options now.

Let’s get right into what all of these options are.

1. Fixed Rate Mortgages

Fixed rate mortgages work exactly how they sound. They maintain the same interest rate over the entire life of the loan. If you get a $500,000 mortgage with a 5% rate on a 30 year term, that means that that 5% rate will stay the same the entire 30 year period of time unless you refinance.

Fixed rate mortgages typically come in terms of 15 or 30 years, however some places have 20 or even 25 year loans, but those are way less common.

You can typically expect a slightly lower rate on a 15 year term than a 30 year term, but you lack the flexibility of a 30 year term. If you have the longer, 30 year mortgage, you can choose to pay extra and pay it off quicker. However, with a 15 year term, you cannot choose to slow it down if your circumstances change.

Yes… you could refinance. But people who picked a 15 year at 3% and are in trouble now do not want to refinance to 30 year at 7.5%.

Refinancing is not always a viable option like many think!

With a fixed rate mortgage, you can also buy down points. For example, you could potentially spend $10k to buy down the rate by .25%. The cost and how much you can buy down will vary, but it can be worth considering. If you think rates will stay or go up, then buying it down could make sense. You have to do the math to see how long it will take to breakeven on that fee to see if it is worth it.

Pros of Fixed Rate Mortgages:

  • Easiest to budget for
  • Certainty on what the payment will be

Cons of Fixed Rate Mortgages:

  • Higher interest rates than adjustable-rate mortgages
  • Only way to get a lower rate is from refinancing

2. Adjustable-Rate Mortgages (ARM)

ARM’s are something that people have not considered in a long time with rates being so low. However, now that rates have gone up they have started to be talked about a lot more.

An ARM comes with an interest rate that changes over time. You typically get a lower fixed rate for a period of time, then after that period the rate changes based on a predetermined interval. For example, you might get a 5/1 ARM. This means that you would get a fixed rate for 5 years, then after that, every 1 year the rate would increase or decrease based on economic conditions until it is paid off.

ARMs typically come with lower interest rates than fixed mortgages which is why people are considering them today. Especially if you think rates will be lower 3, 5, or 7 years from now, they are worth taking a look at. But be careful as you run the risk of rates being even higher then. And typically, with ARMs, you need to put more down to see the benefit of a lower rate.

I know many people who are lining up the term with how long they plan to live there. I am buying a house this year and know I will live there for no less than 5 years, but no more than 7 years, so we are considering an ARM depending on if/how much lower it is than the fixed rate option. We will see when the time comes what is best for us!

Pros of ARMs:

  • Lower introductory rates
  • Can allow you to pay less overtime if rates drop

Cons of ARMS:

  • Risk that rates are higher after the term
  • Harder to budget as there is uncertainty

3. Interest-Only Mortgages

I am not a big fan of interest-only mortgages, but I at least have to educate you on their existence. With an interest-only mortgage, you make interest only payments for a term of 5 or 7 years and then it becomes a loan where you pay both principal and interest after that. With this loan, you won’t build equity in the beginning unless the home appreciates as you are only paying the interest on the loan in the beginning term.

To be honest, I do not see these loans make sense often.

4. Construction Loans

With such a low supply of houses today, many are considering building. If you build, you do not just go and get a typical mortgage. You end up having to get a construction loan. Many times this is a construction-to-permanent loan which basically means you convert to a traditional mortgage once you move in.

These loans can work well for people who are able to put a lot down at first and have the income to afford the monthly payment after.

There are more types of loans than this that exist, but for the sake of this post, these were the one’s that made the most sense to talk about as they are the most common.

If you are about to buy, consider all your options based on you, your life, your goals, your plans, etc. There’s no one right answer for everyone.