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Evaluating Mortgage Types

It took a while to save for the down payment, but you’re finally ready to buy your first home.  And, it didn’t take you long to find the perfect one in a neighborhood that’s safe and friendly, not far from work, with good schools and parks for the kids.  The timing is right and all that’s left to do is shop for a mortgage. 

That’s when the fun and excitement stopped and the hard work began.  For first-time home buyers and even repeat buyers, finding a mortgage can be a tedious and often confusing process.  Not only are there hundreds of mortgage institutions, but many different types of mortgages with different interest rates, lengths and other features.

How do you weed through all the options and determine which one is best for you?  One way is to ask yourself two questions:  How long do I expect to live in the home?  What is my tolerance for increasing monthly payments?

Fixed-Rate Mortgages
As the name implies, with a fixed-rate mortgage, the interest rate is set at the time you take out the mortgage and remains constant over the life of the mortgage. The monthly payments also remain constant.  Knowing what your payments will be for the entire life of your mortgage is not only reassuring, but also allows you to better manage other aspects of your finances and make long-term financial plans.

Each monthly payment is comprised of the interest and principal, with payments made early in the life of the mortgage applied primarily to the interest.  As the interest is paid down, payments toward the end of the mortgage are applied mostly to the principal.

Most institutions offer fixed-rate mortgages of 30 and 15 years. The benefit of the shorter mortgage is that you pay off your mortgage in half the time. You will also pay less interest over the life of the mortgage. The negative aspect is that your monthly payments will be higher.


Comparing a 15-year mortgage and a 30-year mortgage with equal interest rates


15-year mortgage

30-year mortgage

Mortgage amount



Interest rate



Monthly payments (Principal & Interest)



Total monthly payments over the term of the mortgage



Total principal paid over the term of the mortgage


$ 250,000.00

Total interest paid over the term of the mortgage




Choosing the terms of a fixed-rate mortgage is usually a function of the level of monthly payments you can afford and how quickly you want to pay off the entire mortgage.

Adjustable Rate Mortgages (ARMs)
Adjustable Rate Mortgages or ARMs usually have starting interest rates lower than the rates on fixed-rate mortgages. Sometimes it can be as low as 1½ to 2½ % less.  However, with an adjustable rate mortgage, the interest rate and monthly payments can change as interest rates change. The rate is fixed initially but is later subject to adjustments based on changes in an interest rate benchmark. 

There are several features of ARMs that you should be aware of and understand if you are considering this type of mortgage.

  • Initial rate.  If the initial rate is especially low, be careful.  It could be a "teaser" rate that only lasts for a short time.  Find out exactly when the initial rate ends and what the subsequent rate would be.
  • Benchmark of ARM rate.  ARM rates are usually tied to some "published" index that reflects the general interest-rate market.  Usually the ARM rate is adjusted to that index plus a pre-established margin.  Ask the lender how this works and find out how the benchmark rate has changed recently.
  • The cap.  Most ARMs have limits on how much the rate can rise in any one year. Some ARMs have a limit on how high the rate can rise over the life of the mortgage.  Understanding how the caps work will tell you "how bad it could get" if rates rise substantially. 
  • Length of the rate periods.  When you look at ARMs you may find there are terms like 10/1, 7/1, 4/1 and the like.  These refer to how long the initial rate lasts and how often the rate is adjusted after that.

Adjustable rate mortgages are attractive because of their lower initial rate. The tradeoff is that your rate and monthly payment will likely rise in the future.  If you are comfortable with an increase in payments at a future date or if you think you will be moving in a relatively short time, the savings with an ARM can be substantial.

Other Issues

Negative amortization.
Amortization refers to the process of paying down a mortgage.  Some lenders offer mortgages with lower monthly payments than what is needed to pay interest and ultimately pay off the mortgage. This means the amount due on your mortgage increases over time. Avoid this type of mortgage.

Balloon mortgages.
Balloon mortgages are similar to fixed-rate mortgages with steady monthly payments using a 15- or 30-year amortization.  Payments are usually lower than the traditional 15- or 30-year, fixed-rate mortgage because you are only paying on the interest each month. Most balloon mortgages are for 3 to 7 years.  At the end of that period, your mortgage will be due and you must come up with a “balloon” payment for the balance of the mortgage.  If you cannot pay this lump sum or refinance the loan, you could lose your home.

That’s why it’s extremely important for you to fully understand the terms of any mortgage agreement in which you enter.  A mortgage is essentially a long-term debt instrument to borrow money.  It is a contract in which you give the lender a lien on your home as security for the loan.  In exchange, you have use of the property.  Only when the mortgage is paid in full, is the lien removed and you own your home free and clear.

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