When you’re shopping for a mortgage and considering the different mortgage rate options available to you, it can be very confusing. There are multiple financing terms that can seem like they all mean the same thing at first glance, but have very different implications on your monthly payments and overall financing costs. There are many factors that go into determining your mortgage rate, such as your credit score, loan-to-value ratio and whether or not you will be putting down cash as collateral when applying for your loan. Because of this, there are several different types of mortgage rates and payment schedules available to you when applying for a home loan. Let’s take a look at what they all mean so you can choose the one that’s right for you.
Table Of Contents
Fixed-Rate Mortgages
A fixed-rate mortgage is a home loan that has a set interest rate and payment amount for the entire length of the loan. This means that your mortgage rate and payment will never change during the term of the loan, regardless of any changes in the economy or the market. This type of mortgage is most popular among people who are unsure about what the future holds for interest rates and would prefer to have a guaranteed rate for the life of the loan. If you have a fixed-rate mortgage and interest rates increase, you are not able to refinance your loan with a lower rate like you can with an adjustable-rate mortgage. Instead, you will be stuck with your higher payment and have to decide whether or not you are able to make ends meet in the long run.
Adjustable-Rate Mortgages
An adjustable-rate mortgage (ARM) offers a lower initial interest rate than a fixed-rate mortgage, but is subject to change at set points in the future. You will have a set period of time after your loan is initially approved to decide whether or not you want to accept the initial rate offered to you or if you would prefer a different type of mortgage. The most common terms for an adjustable-rate mortgage are a one-year ARM and a five-year ARM. You will want to make sure that you are prepared to make higher monthly payments once your rate goes up, as you will not be able to refinance your loan with a new fixed-rate mortgage.
Variable-Rate Mortgages
A variable-rate mortgage is a mortgage with a changing interest rate. Typically, the initial interest rate on a variable-rate mortgage is lower than that of a fixed-rate mortgage, but could change at any time depending on changes in the economy. Also, because the rate is variable, your monthly payments could be higher or lower than what you initially expected when you applied for the loan. Variable-rate mortgages are not as popular as fixed-rate mortgages as lenders typically view them as a riskier option due to the unpredictability of future interest rates. If a variable-rate mortgage rate is lower than a fixed-rate mortgage rate, it is typically only by a small amount. Given the uncertainty of future interest rates, a small difference in rates is not worth the risk of a variable-rate mortgage.
Interest Only Mortgages
An interest-only mortgage is a type of mortgage where the initial payment does not include any principal repayment at all. Instead, the monthly payment is only for the interest accrued on the loan. This allows the borrower to make smaller payments initially, but you will have to make monthly principal payments over the life of the loan. Because of this, interest-only mortgages typically have shorter terms than fixed-rate mortgages. This way, the borrower will have to make enough principal payments to pay off the loan before the end of the term. Because the initial payment is so much lower than a conventional mortgage, interest-only mortgages are typically used in situations where the borrower has a high income but low savings.
Combination Loans
If you are trying to get a fixed-rate mortgage but the lender thinks the current market conditions make it too risky to approve you for a fixed-rate loan, they could offer you a combination loan. In this scenario, you would receive a fixed-rate loan for the first few years of the loan and then have an adjustable-rate mortgage for the remainder of the loan. This is most common when there are large changes in interest rates over a short period of time and lenders want to ensure that they offer a loan with a rate that is as low as possible. With a combination loan, you will have the option of getting a fixed-rate refinance at the end of the initial loan period, provided the current interest rates are low enough to make it worth your while.
Understanding Mortgage Payments and Rates Together
A mortgage payment is composed of two main parts: principal and interest. The principal is the amount of money you borrowed and the interest is what your lender charges you for the privilege of using their money. Both of these numbers are important to know, but it’s important to remember that the principal is the amount you owe, while the interest is the amount you pay to someone else. Because the amount you pay in interest will change depending on the type of mortgage you have, it’s important to know what to expect.
Wrapping Up
Mortgage rates and payments are both important factors to consider when looking into any home loan. While the initial interest rate does not change and is something you can determine upfront, changes in the interest rate will likely impact your monthly payments and will be out of your control. Regardless of which type of loan you choose, make sure you understand what goes into calculating your mortgage payment so you can make an informed decision.
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