Home buyers face a bewildering array of mortgages _ from traditional 30-year fixed-rate loans to those in which the balance of the principal is due in five years.
Here are some of the options.
30-year fixed rate
With interest rates still in single digits, these are the best loans for home buyers who plan to be in the house more than five to seven years and who want the assurance of level payments.
Rates vary widely, so check with several lenders or use a rate-reporting service. A 1 percentage point increase on a $100,000 mortgage will cost you roughly $26,600 over 30 years.
Points, 1 percent of the mortgage, also affect the value of the loan. Pay two points, or $2,000, on a $100,000 loan, and you're really borrowing $98,000, but you still have to pay back the full $100,000 plus interest. A 9.5 percent mortgage with two points costs more in interest at the end of three years than a 10 percent loan with no points. By five years, the lower rate has begun to pay off.
15-year fixed-rate loans
You pay off this variation on the 30-year fixed-rate mortgage in half the time. Payments are only 15 percent to 25 percent higher than on a 30-year loan, partly because the principal decreases more quickly and partly because rates are slightly lower.
Paying off a mortgage in half the usual time may not be a good idea, even for those who can afford the higher monthly bills. Mortgage interest is tax-deductible, making it one of your cheapest sources of borrowed money. Ask yourself whether the extra you pay on the shorter-term mortgage could earn more than the after-tax cost of the loan if you invested elsewhere.
With variable-rate loans, the interest rate and your payments rise or fall based on the movements of a specific index. The most common ARMs are linked to the average yield on Treasury securities. Others use a weekly average of rates on six-month certificates of deposit (CD-based ARMs) or the average cost of funds for the Federal Home Loan Bank's 11th District bank in San Francisco.
Changes in the rate, which can be monthly, semiannual, yearly or at three- or five-year intervals, are based on the index rate plus a margin of 1 to 3 percentage points. Increases typically are capped at 2 percentage points a year and 5 or 6 points for the life of the loan.
During the past decade, total interest charges on ARMs have typically been lower than those for fixed-rate loans, and their low first-year "teaser" rates helped buyers who couldn't make larger payments afford a house.
First-year rates on ARMs are still 2 percentage points or more below the going 30-year fixed-rate, so they remain the cheapest option for borrowers who sell or refinance in three or four years.
Long-term borrowers will come out ahead only if rates average a little lower than they are now or stay about the same over the next five to seven years, as many economists expect. In that case, you would save around $8,700 on a $100,000 ARM by the seventh year, compared with a 9.5 percent 30-year fixed loan. However, if rates rise the maximum 2 percentage points a year allowed by most ARMs, you could pay some $10,000 more in interest over the same period.
In addition to facing the risk of rising payments, you pay more for mortgage insurance, which lenders require on down payments of less than 20 percent. Also, ARMs have so many variables that lenders sometimes have trouble accurately adjusting payments, so you need to keep an eye on changes.
Avoid ARMs with payments that are capped and an interest rate that isn't. That could cause negative amortization: If payments don't cover the interest, the unpaid amount is added to principal, and interest is charged on that amount. Instead of seeing your balance decline, you may end up owing more than you originally borrowed.
Some ARMs let you convert to a fixed-rate loan without paying refinancing fees. (There may be a nominal charge for processing.) You pay indirectly with a slightly higher initial interest rate or margin or with more points than on a nonconvertible ARM.
Contracts may limit when you can convert, often on the anniversary of your loan, so you may not be able to grab a favorable rate. What's more, the conversion rate is often a half point to 1 point higher than for a 30-year fixed-rate loan.
These are similar to convertible ARMs but with only one adjustment period at either the five- or seven-year mark. The rate can rise no more than 6 percentage points when the loan converts to a fixed rate for the remaining 25- or 23-year term. There are no conversion fees.
These can be good deals if you plan to move before the conversion. You get an initial rate roughly \ percentage point below the 30-year fixed rate for the seven-year loan, slightly more than that for the five-year loan. Savings on a $100,000 mortgage average $1,000 to $3,000 over the five to seven years.
These fixed-rate loans with short terms _ typically five, seven or 10 years _ use the same payment schedule as 30-year loans. Rates are usually \ to almost a full percentage point lower than for a comparable 30-year fixed-rate loan (the shorter the term, the greater the discount) and [ to \ point lower than for a two-step. Low rates make payments more affordable during the first years, but, because so little of the principal is paid off during that time, you must make a large balloon payment when the term ends or refinance.