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How to Decide Between a Fixed Rate and an Adjustable Rate Mortgage

Read on to find out which type of loan is right for you

So you’ve found your dream pad and now you’re in the market for a mortgage? First, you’ll need to decide which type of mortgage you want -- a fixed rate or an adjustable rate.

Not sure what either of those terms mean? Here are the basics to help you decide which type of mortgage will work best for you.

Know the Difference
A fixed rate mortgage has a set interest rate that does not change over the life of the loan. Translation: The interest rate on the loan will not go up or down -- ever. The interest rate on an adjustable rate mortgage, however, varies over time. In other words, adjustable rate loans have a fixed period that lasts anywhere from a month to 10 years, during which the initial interest rate (which is generally on the lower end) remains constant. But after this finite period, the rate will continue to increase over the years. So while the initial interest rate you’d pay with an adjustable rate mortgage might be lower than the interest rate you’d pay for a fixed rate mortgage, the interest rate on an adjustable rate mortgage will increase, meaning you’ll owe more over time. With a fixed rate mortgage, you’ll owe the same interest every time.

Understand the Pros and Cons of Each

Adjustable rate mortgage
Pros:
-They offer lower interest rates initially, so you’ll have lower payments to start.
-You can generally qualify for a larger loan.
-If you can pay off your loan while the interest rates are still low enough, you will save more overall.

Cons:
-You can face sudden and unexpected increases in your monthly payments.
-You run the risk of finding yourself in serious financial trouble (or losing your home) should interest rates rise significantly. (Some adjustable rate loans are structured so that the interest rate can double within a few years, so make sure you understand exactly what you’re getting into before you sign anything.)

Fixed rate mortgage
Pros:
-You are protected from sudden and unexpected increases in your monthly payments.
-They are pretty easy to understand and they don't really change that much from lender to lender.

Cons:
-The interest rates and monthly payments tend to be higher from the start.
-There are stricter requirements to qualify for this type of loan, because the payments are heftier from the start.

Think About the Future
When deciding which type is right for you, keep in mind that there are periods of economic advance and decline and consequently interest rates can rise and fall. As the latest recession has shown, it’s not always easy to predict the health of the economy or what interest rates will do. So you need to figure out the maximum monthly payment you could afford right now and what you believe you will be able to afford in the future. Will you still be able to afford an adjustable rate mortgage should interests rates rise? It’s easy to assume that your earning potential will grow over time, but remember that a lot of people who assumed that found themselves in foreclosure when the economy took a turn for the worse.

If you think you can accurately predict where interest rates will go and you’re sure you can afford the payments even if interest rates rise significantly and/or expectedly and you don’t plan to stay in the house too long or you are sure you will be able to pay off the loan before you believe interest rates will rise again, you could save more with an adjustable rate mortgage in the long run. You’ll get away with smaller payments now (which may prove helpful when you’re still paying off student loans or one of you is in grad school). If you don't plan to live at your house long enough for the rates to rise (or you think you can pay off the loan before they do), then an adjustable rate mortgage could save you some cash. But if interest rates are stable or increasing, and you’d rather know exactly how much you’ll owe each month (or you just don’t like gambling on interest rates), then your best bet is likely a fixed rate mortgage.

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-- The Nest Editors

See More: Mortgages , Real Estate