Homebuyers and homeowners planning to refinance have two main choices of home loans: fixed-rate mortgages and adjustable-rate mortgages.
Each of these home loans has pros and cons that borrowers need to weigh before choosing the best loan for their budget and lifestyle.
With fixed-rate mortgages, borrowers pay the same interest rate every month for the entire life of the home loan. Many borrowers who choose fixed-rate loans opt for a 30-year fixed-rate mortgage, but 10-, 15- and 20-year fixed rate home loans are also available. In some cases, even longer mortgage terms can be found.
Because fixed-rate home loan costs remain stable over the life of the loan, borrowers have the security of knowing they will not be hit with an increase in their monthly payment should mortgage rates rise. Borrowers know their financial commitment right off the bat and can therefore budget accordingly.
However, mortgage rates on fixed-rate home loans tend to be higher — at least initially — than on adjustable-rate mortgages. In addition, borrowers should beware that the longer it takes to pay off a home loan, the more the home will ultimately cost in terms of interest payments.
As its name implies, the interest rate on an adjustable-rate mortgage, or ARM, varies over time. An ARM is tied to a specific type of index that determines the rate the borrower pays. Some of the most popular ARM indexes are known by their acronyms and include Libor, COFI, MAT and CMT.
Borrowers who choose an ARM are likely to see their monthly payments go up or down during the life of the loan, depending on the direction of the rate index to which the home loan is tied.
There are different types of ARMs, ranging from hybrid ARMs — which offer a fixed-rate for a specific number of years, before the rate adjusts at a pre-determined point in the future — to one-year ARMs, which have no fixed-rate period.
On these types of home loans, borrowers commit to a certain price for a certain period and then take their chances. ARMs may be beneficial for some types of borrowers, especially those who do not plan to own their home for very long and anticipate selling the property before their ARM adjusts.