Fixed Rate Loans versus Adjustable Rate Loans
With a fixed-rate loan, your monthly payment of principal and interest never changes for the life of your loan. Your property taxes may go up (we almost said down, too!), and so might the homeowner's insurance premium part of your monthly payment; but generally with a fixed-rate loan your payment will be very stable.
During the early amortization period of a fixed-rate loan, a large percentage of your monthly payment goes toward interest, and a much smaller part toward principal. That gradually reverses itself as the loan ages.
You might choose a fixed-rate loan if you want to lock in a low rate. If you have an Adjustable Rate Mortgage (ARM) now, refinancing with a fixed-rate loan can give you more financial stability.
Adjustable Rate Mortgages - ARM's, as we called them above - come in many varieties. Generally ARMs determine what you must pay based on an outside index, perhaps the 6-month Certificate of Deposit (CD) rate, the one-year Treasury Security rate, the Federal Home Loan Bank's 11th District Cost of Funds Index (COFI), or others. They may adjust every six months or once a year.
Most programs have a "cap" that protects you from your monthly payment going up too much at once. There may be a cap on how much your interest rate can go up in one period - say, no more than two percent per year, even if the underlying index goes up by more than two percent. In addition, almost all ARM programs have a "lifetime cap" - your interest rate can never exceed that cap amount, no matter what.
ARM's often have their lowest, most attractive rates at the beginning of the loan and can guarantee that rate for up to ten years. You may hear people talking about, or read about, what are called "3/1 ARM's" or "5/1 ARM's" or the like. That means that the introductory rate is set for three or five years, and then adjusts according to an index every year thereafter for the life of the loan. Loans like this are often best for people who anticipate moving - and therefore selling the house to be mortgaged - within three to five years, depending on how long the lower rate will be in effect.
You might choose an ARM to take advantage of a lower introductory rate and count on either moving, refinancing again or simply absorbing the higher rate after the introductory rate goes up. With ARM's, you do risk your rate going up, but you also take advantage when rates go down by pocketing more money each month that would otherwise have gone toward your mortgage payment.