The explosion of new types of mortgages in recent years has made picking out which one is right for you almost as difficult decision as picking out your home.
The basic types are fixed and adjustable rate mortgages, known as ARMs, which start out with a low, fixed rate, then re-adjust after a set number of years, often sending payments way up. ARMs accounted for 32 percent of loans last year, up from 11 percent in 1988.
Thanks to the housing boom, banks are offering nearly as many varieties and flavors of mortgages as Starbucks offers of coffee. The major innovations are interest only mortgages, which allow payments of interest only for the first few years, and option mortgages, which allow you to decide each month how much you will pay, ranging from a bare minimum interest payment to a chunk of the principal.
Each of these loans was designed for a specific homebuyer. "There is nothing wrong with the products and everything wrong with how people use them," says Ben Utley, a financial planner in Eugene, Oregon. What worries financial advisors is that many homeowners appear to be using these exotic mortgages simply to maneuver their way into bigger house.
Christopher Cagan, an economist at First American Real Estate Solutions, calculated that the higher payments on ARMs will set off one million defaults over the next five years. "The impact of this won't break the economy, but it will sting those immediately involved," he says. To decide which mortgage is right for you, consider which circumstance each is designed for.
30-YEAR FIXED RATE This standard bearer allows steady, predictable payments. The burden of this loan will ease in time as inflation--and your potential wage growth--makes the payments seem smaller. The disadvantage is that the payments will be higher than those initial low teaser rates of an ARM, so you won't be able to afford as big of a house.
15-YEAR FIXED RATE If you can afford it, a 15-year mortgage offers quicker repayment and faster equity build-up. The rate is usually lower than the 30-year, so interest expenses are much lower. The current 30-year rate is 6.2 percent while the a 15-year goes for 5.9 percent.
5/1 ADJUSTIBLE RATE MORTGAGE An adjustable rate mortgage allows you to start off with low payments and afford more house now. Two numbers identify these loans: the first is the number of years until the rate resets and the second is how often it will reset. These are for people who expect to move before the rate jumps. Americans typically move every seven years. If you expect your income to rise or to pay off a big expense (such as school loans) they might be right for you, too.
1/1 INTEREST ONLY MORTGAGE An interest only mortgage allows buyers to pay just the interest on a mortgage at first. Then, payments spike. A mortgage that resets in one year bets that interest rates have plateaued or are headed down. People who get these loans are typically counting their house value to rise, a strategy that worked well in recent years, but may not now.
OPTION MORTGAGE You can decide each month whether you’ll just pay the interest or work off some principal. This mortgage is designed for those with an erratic income, say, someone who gets a big bonus. The minimum payments are so low that you may actually sink deeper into debt with each minimum payment.
40-YEAR or 50-YEAR MORTGAGES You can get slightly lower monthly payments by stretching out the loan for a decade or two, but at a high cost. Someone with a 30-year $300,000 mortgage would pay $1,837 a month, for a total interest cost of $361,466. By stretching the loan out for 50 years, they would only save $213 a month and end up paying about $300,000 more in interest.
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