Understanding Mortgages: Fixed rate mortgages versus Adjustable rate mortgages

Home buyers have enough to think about without having to educate themselves on the intricacies of the mortgage and lending industry! So in this article, and in other “understanding mortgages” articles to come, we will look at various types of mortgages and help you understand what they are and which one might be right for you.

The very first thing you’ll want to know is the fundamentals; we can go into greater detail in other articles.

There are 2 types of mortgages: fixed rate mortgages and adjustable rate mortgages. Other mortgages, which you’ll read about from time to time, are just hybrids and versions of these two basic mortgage types.

The “rate” in Fixed rate and Adjustable rate mortgages refers to the interest rate you’ll pay when you get your mortgage.

You see, banks take a chance when they lend you money. They’re risking that you might not pay them back, for whatever reason, so they charge a fee to lend you money for your mortgage… that “fee” is interest. It’s like paying regularly for a service you receive (in this case, the service is your mortgage).

Every mortgage payment you make is made up of 4 things, called “PITI” in the interest. This stands for Principal (the amount of the actual loan), Interest (the “fee” the bank charges to loan you money), Taxes, and Insurance.

In a fixed rate mortgage, the interest rate is set for the entire term of the loan. So let’s say that you went to the bank and asked for a 10 year mortgage at 7% interest. You can be sure that each and every month you’d be paying that 7% interest over the 10 years of your mortgage. This is true no matter how long the mortgage is. As you can imagine, this is a great mortgage to have if interest rates rise. If you “lock in” at 7% and interest rates suddenly skyrocket, you’ll thank your lucky stars that you’re set to pay 7% from now until you finish your mortgage. But the same holds true the other way: if you “lock in” at 7% and interest rates plummet, you’ll regret having locked in for that period of time with a fixed rate mortgage.

In an adjustable rate mortgage (sometimes called an ARM for short), the interest rate is, you guessed it, adjustable. That means it fluctuates with the actual interest rate set by the Federal Reserve. If they set the interest rate at 7% one month, then 5% the next month then 10% the next month, your mortgage payments will fluctuate. You’ll pay the standard principal, taxes, and insurance that you expect to pay, but your payments will drop from the 7% month to the 5% month and then rise from the 5% month to the 10% month. An ARM is good if you think interest rates are likely to go down and you don’t want to lock in. On the other hand, you need to be prepared for mortgage payments that are not exactly the same from one month to the next.

This article may not make you an expert on mortgages, but it’s the fundamental basis that other mortgage types are built off of. In coming articles we’ll look at a few additional types of mortgages and you’ll see how they are related to one of these two types.

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