Buying a home involves a lot of big decisions that have long-term implications. You don't want to choose the wrong paint color for your living room, but -- trust us -- an even more important choice is picking the right loan.
Home loans fall into two camps: fixed-rate or adjustable-rate mortgages. Let's weigh the pros and cons.
Fixed rate means no surprises
A fixed-rate mortgage keeps the same interest rate for the life of the loan.
This means no matter what happens to interest rates out there in the world, yours will never change. If rates go skyrocketing, yours won't. Whew! But if they fall, yours will remain stuck at the old, higher levels.
Because your interest rate won't go anywhere, your monthly mortgage payment will stay the same, too. That is, it will unless it includes property taxes, insurance premiums or homeowners or condo fees that could change.
An adjustable rate can keep you guessing
An adjustable-rate mortgage, or ARM, starts out like a fixed-rate loan, with an interest rate that's steady for a certain number of years. After that, the rate can start "adjusting," or moving. That means your monthly payment also can change.
An ARM will be described in terms of two numbers, such as a "5/1 ARM" or a "3/5 ARM." The first tells how many years the rate will hold during your introductory period. The second tells how often the mortgage rate will adjust after that.
So, a 7/2 ARM is fixed for the first seven years and then adjusts every two years. But most often, the adjustments come annually.
Rates are adjusted according to changes in a financial index, such as something called Libor. And, you should understand that an ARM rate has the potential to increase or decrease. Because who knows where interest rates will go?
Here's another important point: "Some ARMs set a cap on how high your interest rate can go," says the U.S. Consumer Financial Protection Bureau. "Some ARMs also limit how low your interest rate can go."
To boil it all down...
Fixed-rate mortgages usually have a higher interest rate than the initial rate on an ARM, but you won't have to worry about your fixed rate ever going up. It also won't ever go down.
ARMs usually start with a lower interest rate than fixed-rate mortgages, but there is potential for your rate to either increase or decrease over time.
How do you pick?
In personal finance, you rarely find clearly defined right or wrong answers. The better type of mortgage depends on what fits your circumstances.
A fixed-rate mortgage is more attractive if you might be in the home a long time. You can feel assured that your mortgage rate will never go up — and drive your payment higher.
An ARM is better if you might sell the house in five years, seven years — however long you have before the loan starts adjusting. You can enjoy the low interest rate at the start of the loan and get out before the mortgage has the potential to get more expensive.