What are the different types of mortgages and which mortgage is right for me?

There are many different types of mortgages, but the two main differences are the duration of the mortgage (the time period the mortgage is paid off over), and the length of time the interest rate is initially fixed.  Let’s take a closer look at that differences.

 

Should I Get a 15 year Mortgage, or a 30 Year Mortgage?

The duration of the mortgage is the time period that the mortgage is repaid over.  The two most common durations are a 30-year mortgage and a 15-year mortgage.


You can expect to have a lower monthly payment on a 30-year mortgage compared to a 15-year mortgage.  Put simply, you are repaying the same amount over a longer timeframe, and thus your monthly repayment amount is lower.  Viewed another way, for the same monthly payment, you can take out a larger mortgage (and buy a more expensive house) if you take a 30-year mortgage compared to a 15-year mortgage.


However, you will generally get a lower interest rate on a 15-year mortgage compared to a 30-year mortgage.  And, because you are paying your mortgage off over a shorter time period, you will pay less interest over the life of the mortgage.


As an example, let’s compare a 15-year mortgage at 3.25% interest rate, with a 30-year mortgage at 3.75%.  Let’s assume the amount of the mortgage is $2,000,000 in both cases.



15-year mortgage

30-year mortgage

Interest rate

3.25%

3.75%

Monthly minimum payment

$14,053

$9,262

Total payments

$2,529,608

$3,334,432

Total interest payments

$529,608

$1,334,432


We can see from the above example that the monthly payment for the 15-year mortgage is 1.5 times larger than for the 30-year mortgage.  However, over the life of the mortgages, the 30-year mortgage pays 2.5 times as much interest.


Which mortgage duration is right for you?

So, you’re much better off with a 15-year mortgage if you can afford the higher monthly payments.  You’ll pay significantly less interest over the course of the mortgage, and you’ll be fully paid-off in half the time.  However, the monthly minimum payment is significantly higher for the 15-year mortgage, and you need to be comfortable making the higher monthly payment if you choose this option.  A lot of buyers who can only just afford the 15-year mortgage’s monthly minimum payment elect to get a 30-year instead, and make additional principal repayments each month to pay off their loan quicker while retaining the flexibility of a lower monthly minimum payment in case of any unexpected financial bumps.



What’s the Difference Between A Fixed Rate and an Adjustable Rate Mortgage?

30-year mortgages offer different periods that the interest rate is fixed for.  At one end of the spectrum you have a fixed rate mortgage which, as the name suggests, has a fixed interest rate for all 30 years.  That means that as interest rates go up and down, the mortgage holder still pays the same interest rate that was ‘locked in’ at the time their loan was issued.  The monthly payment is the same for all 30-years and thus a fixed rate mortgage is easier to budget around.


The alternative to a fixed rate mortgage is an adjustable rate mortgage (ARM).  An ARM has an initial period that the interest rate is fixed, but then the mortgage’s interest rate will fluctuate up and down with the market’s interest rates.  That means that if interest rates go up, the minimum monthly payment for the mortgage will also go up, and vice versa.


ARMs are generally expressed in terms such as “5/1”, “7/1” or “10/1”.  The first number indicates how long the initial interest is fixed for. So, for example, a “7/1 ARM” has a fixed interest rate for the first 7 years of the mortgage.  The second number indicates how frequently the ARM’s interest rate is re-assessed. A “7/1 ARM” has the rate adjusted every one year.


In today’s economic environment, your initial interest rate is higher the longer that it is fixed for.  So, a fixed-rate mortgage will have a higher interest rate than (the initial rate of) an adjustable-rate mortgage.  And the initial rate for a “10/1 ARM” will be higher than the initial rate for a “5/1 ARM”. 30-year mortgage-holders are trading off the certainty of their future interest rate by paying a slightly higher rate than they could get with an adjustable rate mortgage.


ARMs are tied to market interest rate, known as an “index”.  The most common index is the one-year LIBOR rate (London Interbank Offered Rate), which is published daily in the Wall Street Journal.  After the initial fixed rate period, the interest rate on your mortgage will depend on the movement of the index, which is driven by market forces.


ARMs also have a rate cap structure.  A typical rate cap structure is expressed as “2/2/6”.  The first number indicates the maximum the interest rate can increase after the initial fixed period.  The second number represents the maximum the interest rate can increase in any subsequent year. The final number represents the maximum the interest rate can increase over the life of the mortgage.  So even if interest rates skyrocket like they did in the late 70s / early 80s, your mortgage interest rate could only go up 6% above your initial fixed rate.


Is fixed rate or adjustable rate mortgage right for you?

Determining whether to choose a fixed-rate or adjustable-rate depends on two factors.  The first factor is how long you intend to stay in your home (or more precisely, how long you intend to keep your mortgage outstanding).  If you plan to sell your home or pre-pay your mortgage in 10 years or less, you should take an adjustable rate mortgage that has a fixed term that corresponds to how long you intend to keep the mortgage.  This gives you the benefit of a lower interest rate, and given that you’ll have paid off the mortgage before the floating interest rate begins, you’ll never have to worry about interest rate increases.


The second factor is your view of interest rates over the next 30 years.  If you believe that interest rates are going to increase in the future, and you would prefer a fixed monthly payment amount, then you are better off with a fixed-rate mortgage.  You may end up paying a higher interest rate, but you’ll never have to worry about interest rates going up substantially, and having a much higher monthly payment amount. The fixed rate mortgage gives you peace of mind, albeit with a slightly higher interest rate.

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