Borrowing money to buy a home is an intimidating process. Mortgages can be complicated — there are several types, and those types have a lot of variations. But you don’t need to become a loan expert to get a mortgage. Take it one step at a time.
Start here with the basics on the most common mortgages:
When shopping for a home loan, one of the first questions to ask yourself is whether you want a fixed-rate or adjustable-rate (ARM) mortgage. There are similarities. Among them:
- Both types let you borrow a big chunk amount of money and repay it slowly in monthly payments.
- With both, your first years’ payments go mostly toward repaying interest on the debt and then, as time goes on, your equity in the home grows faster.
- Both types require you to demonstrate your creditworthiness by disclosing details about your debts, assets, income, credit score and credit history.
Despite all they have in common, though, fixed-rate loans and ARMs are set up differently.
Fixed-rate mortgages are predictable, and safer, for borrowers. They’re usually longer-term loans: 30-years is standard, but you also can get 10- and 15-year fixed-rate mortgages.
With a fixed-rate mortgage, your interest rate is locked in when you get the loan. It stays the same as long as you keep the mortgage — until you sell, refinance or pay it off. If your mortgage rate is 4 percent at the start, it will be 4 percent in 30 years, if you keep it that long.
A fixed-interest-rate mortgage is best for borrowers when:
- Interest rates are on the way up.
- You expect to stay in the home for five years or more.
With an ARM (also called variable-rate mortgages), the interest rate changes over time. An ARM usually starts with a “teaser” interest rate that’s lower than the market rate. After a period of time specified in your contract, the interest rate adjusts (or resets) on a regular basis. These adjustments cause your monthly payment to change, too.
ARMs, like fixed-rate mortgages, can be for any length of time, although 30-year mortgages are popular. The rules for your ARM will be spelled out in your contract. Be sure to read it before, not after, you sign the mortgage papers.
ARMs differ. For example, your rate might reset monthly, every six months, every year or some other period. These contracts can be complex — even the reset cap can change during the life of the mortgage. That makes it important to read the fine print carefully and, if you are confused, to get help from a knowledgeable friend, relative or attorney. Another good place to learn more is the federal Consumer Financial Protection Bureau’s Handbook on Adjustable Rate Mortgages.
A few years ago, ARMs looked good because mortgage rates were falling and your monthly payment had a good change of shrinking. (Check out: “Adjustable Rate Mortgages Look Good. Should You Bite?”) Not today, though. When interest rates are rising, as they are now, your monthly payment is likely to grow bigger over time. In 2015, few homeowners are buying ARMs, as this Business Insider chart shows.
Find out the worst-case scenario
Before committing to an ARM, learn what your highest possible monthly payment could be. If for some reason you can’t sell or refinance, you’ll have to be able to afford every possible payment. If you can’t, don’t get the mortgage.
Many, many homeowners lost their homes in the housing crash because they were stuck with ARMs whose payments kept resetting higher and they couldn’t sell or refinance to get out of the loans after their homes’ value had fallen to less than the amount they owed on the mortgage.
An ARM is a good idea when:
- Interest rates are falling (so your payments will stay the same or become smaller).
- You plan to sell or refinance before the rate can adjust significantly.
- Your income is certain to grow enough that a bigger house payment won’t endanger your finances. Simply hoping you’ll eventually make more money is risky and doesn’t count.
A third mortgage type is a hybrid. Like hybrid cars, these are part one thing and part another, in this case, part fixed-rate and part adjustable.
You’ll see hybrid mortgages shown with two numbers separated by a slash. A 5/1 hybrid mortgage has a fixed-rate period lasting five years. The 1 indicates that after the five-year fixed rate period the mortgage becomes adjustable with the interest rate resetting (adjusting) every year. A 7/1 hybrid ARM has a seven-year fixed-rate period; after that the rate resets every year. The loan itself can continue for many years after the fixed-rate period is over — 30 years, for example.
Hybrid ARMs are a good idea when:
- You will sell the home or refinance before the fixed-rate period ends.
3 tips for finding a mortgage
Here are three ways to stay safe and save money when mortgage shopping, regardless which mortgage type you settle on:
1. Comparison shop. Meet with and apply to several lenders or mortgage brokers. Compare their offers and contract terms just as you would when shopping for a dishwasher or car. If you are among the 77 percent of borrowers who apply with only one mortgage broker or lender, you stand to lose tens of thousands of dollars. The mortgage page of our Solutions Center is a great place to start.
2. Get help reading the contract. Even the reset cap can change during the life of the mortgage, making it crucial for buyers to read the (often-confusing) fine print carefully when taking on an ARM. Ask a trusted friend, relative or attorney to help you carefully review a mortgage contract before you sign.
3. Remember: You can back out. You have three days to back out (or rescind) after signing any type of mortgage contract. “Unless you waive your right of rescission, you have until midnight of the third business day after the mortgage closing to cancel the contract,” the Consumer Financial Protection Bureau says.
Mortgage shopping? Tell us about your experience and the lessons you learned in the comments below or on our Facebook page.