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Traditional Mortgages

Understanding Traditional Mortgages

When shopping for a mortgage, you have important choices to make. For most borrowers, the traditional fixed-rate mortgage and adjustable-rate mortgage (ARM) continue to be excellent options. However, even these traditional financing options require a number of decisions. Should you get a 15- or 30-year loan? Should you get a fixed-rate mortgage to lock in today’s interest rates for the term of the loan—or take an adjustable-rate loan with a lower current rate and payment, but with the risk of rate and payment increases in the years ahead?

You can also tap the equity in your home by refinancing your existing mortgage, taking out a second mortgage, or obtaining a home equity line of credit. This website helps you consider these options as well.

We hope this website will help with some of the basics about traditional mortgages. To make the choice that is best for you, you’ll want to select a lender and then discuss the options with them.

Fixed-Rate Mortgages: With a fixed-rate mortgage, you are guaranteed the same interest rate over the life of the loan. Your monthly principal and interest payments never change, and the loan is paid off completely over the term you select.

The key choice involves how long you have to pay back the loan. The most common options are 15- and 30-year loans, with the 30-year being the most popular. As this chart illustrates, a shorter-term loan comes with both a lower interest rate and higher monthly payments. This means you can build equity and pay the loan back faster. Rates, and the differences between rates for 15- and 30-year loans, change daily.

Adjustable-Rate Mortgages: The initial interest rate on an adjustable-rate mortgage (ARM) is generally lower than that for a fixed-rate loan. However, with an ARM, the interest rate may increase or decrease in the future, and the size of your payments will go up or down along with the rate.

Most ARMs are "hybrids," meaning that the interest rate is "fixed" for a certain number of years, after which the rate can adjust. The most common ARMS fix the initial rate for three, five, or seven years. ARMs are probably most appropriate for people who have sufficient financial resources to handle potential payment increases or know that they plan to sell their home around the time the loan’s interest rate is set to change.

Important Features of Adjustable-Rate Loans:

Before agreeing to an ARM, you should ask the following questions:

• How long does the initial interest rate apply?
• How frequently can the interest rate change?
• How is the adjusted interest rate determined? (Generally, a specified amount, the "margin," is added to a current published rate, the "index.")
• How high can the interest rate go?
• Does the loan set a minimum interest rate?
• What are the limits on how much the interest rate can change with each adjustment and over the life of the loan?
• Do the monthly payments still pay off the loan even if interest rates increase? (With some loans, the amount you still owe—your "loan balance"—can increase rather than decrease each month. This is called negative amortization.)
• What is the maximum monthly payment that you could be required to pay at the first adjustment?

Potential Pitfalls of ARMs: Even small changes in your interest rate can increase your monthly payment significantly, resulting in "payment shock." Even a change of 1% or 2% in interest rates can result in a very big jump in your monthly mortgage payment. For example, if the interest rate on your mortgage changes from 4% to 6%, your monthly payment could rise by as much as 50% (from $1,000 to $1,500).

ARMs can be complicated, and many specialty ARMs (with risky terms appropriate only for a small group of borrowers) are now being marketed widely. Be sure to avoid loans with terms that you don’t understand. Work with a trusted lender to be sure you understand your options.