One of the most important decisions you’ll make when you buy a house is how you will finance that purchase. Most home buyers can’t pay cash for a house, so finding the right mortgage is critical. A fixed-rate mortgage has both advantages and disadvantages, and you will need to decide if it is the best option for your specific financial situation.
Traditionally, a fixed-rate mortgage is the most popular option for home buyers. When you choose a fixed-rate mortgage, the interest rate is set when you first get the mortgage, and it stays the same for the life of the mortgage. As a result, your monthly principal and interest payment stay the same.
When you get a fixed-rate mortgage, your lender will give you an amortization schedule. Amortization refers to the process of paying off a debt with regular payments. The schedule will show you how much of your monthly payment goes to paying down interest and how much goes to paying down the principal, which is the amount you financed.
What you’ll notice is that at the beginning of the loan, the biggest portion of your payments will go toward paying interest. Over time, the amount of your payment that goes to interest will decrease and you’ll pay more against the principal. This means that the lender will get a reasonable amount of interest to cover their risk, even if you sell your home in a few years.
Fixed-rate mortgages come from a variety of sources, and term lengths typically range between 10, 15, 20, 25, or 30 years. In general, there are two types of fixed-rate mortgages, conventional and government-backed.
Conventional mortgages are also called conforming mortgages because they meet requirements set by Fannie Mae and Freddie Mac. Congress created those two agencies, and they set standards for the mortgage industry. They also buy mortgages from lenders to free up the lender’s capital to do more lending.
Several government agencies offer mortgage loans. Their programs are aimed at specific types of home buyers and offer some special features. These are just three alternatives.
VA Mortgages. The Department of Veteran Affairs offers loans to home buyers with military experience. The loans carry low interest rates and don’t require a down payment.
FHA Mortgages. The Federal Housing Administration offers loans that are targeted at low to moderate-income home buyers. As compared to conventional mortgages, these loans have lower down payment requirements and have more flexibility for the borrower’s credit scores.
USDA Mortgages. The Department of Agriculture offers loans to low to moderate-income home buyers who are buying in a qualified rural area. USDA loans typically have below-market interest rates and have no down payment requirements. The loans do require mortgage insurance to guarantee the loan. Home buyers typically pay an upfront fee and a small monthly premium that is incorporated into the principal and interest payment.
While the loans primary goal is to help develop suburban and rural areas, you may be surprised to know that 97 percent of the land in the US is USDA-eligible. This loan program isn’t the most well known, but it could benefit many home buyers.
Fixed-rate mortgages are the most popular type of mortgage, and there are good reasons for that. But, there are also some disadvantages, so you need to look at both before you make a decision.
You also need to know the basics of an Adjustable Rate Mortgage (ARM), which is your other alternative. In summary, an ARM loan starts with an interest rate that is fixed for a period of time, then the rate will fluctuate based on what’s happening with interest rates in the market. Therefore, if rates go down, your monthly payment decreases. But, if rates go up, your mortgage payment will be increased periodically.
1. No change in interest rates. During the time you own a home, many things can change. The interest rates will undoubtedly change, the economy can be weak or strong, and you may have improvements or disappointments in your own financial situation. But, the interest rate on your mortgage will stay the same, which gives you some stability.
2. No change in your monthly payment. It’s easy to do financial planning when you know exactly how much your mortgage payment will be. Unlike ARM loans, your payment on fixed-rate mortgages won’t suddenly increase.
3. No rush to refinance. If you get an ARM, you may need to refinance once the interest rate increases to the point where your monthly payments aren’t comfortable. The problem is that you don’t know where the interest rates will be at that time, and you may not be able to lower your payment to a comfortable level.
4. Appealing when interest rates are low. Fixed-rate mortgages typically carry a higher interest rate than an ARM. But, if interest rates are already low, having a guaranteed interest rate for the term of the loan is more attractive than an ARM that might have a 1% lower interest rate initially, but is susceptible to significant increases if interest rates rise.
5. Term customization. Fixed-rate mortgages offer a range of terms. Shorter-term loans have lower interest rates, but higher monthly payments. If you wanted to reduce the amount of interest you’ll pay over the life of the loan, and could afford the higher payment, shorter-term fixed-rate loans give you that alternative.
6. Stability. Probably the biggest benefit of a fixed-rate loan is that you don’t need to worry about changes in your monthly payment. If you get an ARM, you’ll need to redo financial plans every time the interest rate changes, and that can increase the risk of owning your home.
1. Higher interest rates. For conventional mortgages, the interest rates on a fixed-rate mortgage are typically higher than an ARM’s initial rate. Therefore, you will pay more interest over the life of the loan. And, since you pay more of the interest than the principal in the early years of the loan, you may end up paying more interest even if you sell the home or refinance the loan.
2. Higher monthly payments. Since the interest rates on conventional mortgages are higher than an ARM, your monthly payments will be higher initially, also. However, since an ARM interest rate can go up, that may not always be the case.
3. Must refinance to take advantage of lower interest rates. With an ARM loan, if the interest rates fall, so does your monthly payment. With a fixed-rate loan, the only way to take advantage of falling interest rates is if you refinance. Refinancing is a good strategy, but there are often costs associated with it. And, if your income has gone down, or the value of your home has gone down, you may not be able to refinance at the most advantageous time.
4. Mortgage insurance may be needed. For many conventional mortgages, if you put less than 20% down on your loan, you will pay Private Mortgage Insurance (PMI). The insurance premium will be added to your monthly principal and interest payments until your mortgage balance equals 78% of the value of your home.
It’s important to note that some government-backed mortgage loans do not share the disadvantage of higher interest rates, although you must consider the additional fees some of those loans require.
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