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Types of Mortgages
How much house you can buy also depends on your mortgage’s term and interest rate. The term is the length of time (usually 15 or 30 years) over which payments will be paid. The rate can be fixed (meaning it doesn’t change over the loan’s term) or adjustable (it fluctuates with market conditions). Thirty-year fixed-rate mortgages remain the most popular. The longer term lowers the monthly payment, while the fixed rate provides stability over the life of the loan. Given relatively low interest rates, these mortgages are attractive to buyers planning to stay at least six or seven years in their new home. The drawbacks are low principal payments in the early years, and the risk that market rates will decline over the term. However, if your credit history is sound and you have sufficient income, you can usually refinance your mortgage when rates decline.

A 15-year term lowers the interest rate, reduces total interest payments, and increases principal payments. But it also increases monthly payments. If you can’t afford the higher payments now, you might opt for a 30-year mortgage. If there are no prepayment penalties, you can make additional principal payments as your income increases. Making just one extra monthly payment a year will pay off a 30-year mortgage in less than 22 years and can save tens of thousands of dollars in interest costs. If you plan to stay in a home no more than three years, you might want an adjustable-rate mortgage (ARM). ARMs offer initial rates that are lower than fixed mortgages. At some point, usually after the first year, rates are tied to market conditions and are subject to potential rate increases. Most ARMs include a cap on rate increases in any given year, as well as over the life of the loan. Some ARMs offer initial rates at least 2% below fixed rates and limit increases to 1% annually and 5% to 6% over the life of the loan. Many home buyers are attracted by the affordability of an ARM during the initial period. However, you should be confident that your future income will be sufficient if both interest rates and your monthly payments increase.

Another popular mortgage involves a balloon payment. A balloon is a lump-sum payment that pays off the loan in full after a fixed period of time. Generally the rates on balloon mortgages are 1/4% to 3/4% less than on 30-year fixed mortgages, but during an initial period of between 3 and 15 years, payments are similar. After this period, the remaining outstanding principal balance is either due in full or subject to refinancing. This is a good option for home buyers who plan to sell before the final payment is due. But because property values fluctuate, you may not be able to sell when you want. You may also face higher payments if you are forced to refinance at a higher rate, and there is also a risk that you may not be in a position to refinance when the balloon becomes due.