Fixed and Adjustable Loans

At the most basic level, mortgages come in two categories: fixed rate and adjustable-rate. In both cases, "rate" refers to the rate of interest the you pay the bank for the privilege of borrowing its cash.

Fixed-Rate Loans

With a fixed-rate mortgage, the interest rate doesn't change over the life of the loan, no matter how interest rates fluctuate on the open market. Many people feel more comfortable with a fixed rate, because they know their monthly mortgage payments will remain steady over the years, making at least one aspect of their monthly cash flow predictable. The downside is that you pay for that comfort: Lenders charge a higher rate of interest for fixed-rate loans. Why? Because they figure that if interest rates shoot up, they lose the opportunity to make more money on the funds they are lending you.

The standard fixed loan lasts for 30 years, but if you can handle higher payments and want to build up your equity in your home faster, you can opt for a 15-year fixed-rate loan. With a 15-year loan , you'll get a lower rate and pay much less interest over the life of the loan. The payments each month, however, will be quite a bit higher than a 30-year loan since they aren't being stretched over so long a period.

Here's an example: If you get a $125,000 loan with a 30-year fixed rate of 7.75%, you'd be on the hook for monthly payments of $895.52. On a 15-year version of the same loan, you might get a rate of 7.25%, but your monthly payment would be $1,141. If you were cash-short and wary of higher monthly payments, you would go with the 30-year loan. But, ultimately it would cost you. On the 30-year loan, you pay a total of $197,386 in interest over the life of the loan, while the 15-year mortgage costs you only $80,394.

A fixed rate makes the most sense for those who plan to stay put in their new home for a long time. You pay a little more in interest, but it is stretched over a longer period so the monthly effect can be minimal. And, if you're buying when rates are low, locking in a good deal is probably worth it.

Adjustable-Rate Loans

Adjustable-rate loans get their name because the rate you pay changes according to a set formula as interest rates fluctuate on the open market. As noted above, the upside is that lenders charge a lower rate for such loans because you are taking on some of the interest-rate risk. This makes your monthly payments lower — at least in the beginning. Such loans provide a way for many buyers to afford a larger loan amount for a given monthly payment. An adjustable-rate loan works out wonderfully if rates drop, but that’s something you should never count on. And, watch out if interest rates rise. In a year or two, your payments could far exceed what you would have paid for a 30-year fixed.

The trick with adjustables is to tailor the loan to your needs. Generally, the cheapest rate out there is on a one-year adjustable. (Well, yes, there are even cheaper loans that adjust monthly, but those are too esoteric for most buyers.) With a one-year, your rate can change annually, making these loans particularly risky. Lenders often try to draw you in with "teaser" rates that are especially cheap for the first year, but which will almost certainly jump up the next year.

There is a limit to how much an adjustable rate can adjust. Lenders limit the amount the rate can rise, often to no more than two points a year, with a lifetime cap of six points. If you are willing to endure the hassle and expense of refinancing after a year, it's possible you'll come out ahead.

A slightly more expensive option is what's known as a "delayed adjustable." When you see "3-1 adjustable" or "5-1 adjustable" it means that the loan stays fixed for three or five years and then resets annually. The same pattern holds for a 7-1 or a 10-1. The longer the fixed period, the higher the rate. The idea is to match the loan to the amount of time you plan to stay in the house. For instance, if you expect to move after three years, a 3-1 is a great option. After 10 years, you might as well opt for a fixed rate. The price difference will be minimal.

Figuring out which kind of loan makes sense for you depends entirely on your circumstances and temperament.