A Definitive Guide to Mortgages—And How to Pick the Right One
A crucial step in the homebuying process is getting the financing right. In fact, buying a house is often the easiest part — the real challenge is figuring out how you’re going to pay for it. And the key to making it all work financially is getting the right type of mortgage.
There are a ton of different kinds of mortgages to choose from. Before we dive into all of your options, let’s start with the basics.
What is a mortgage?
Very simply, a mortgage is a loan you get — usually from a bank or other financial institution — so you can buy a house or other piece of real estate. What makes it a mortgage as opposed to an ordinary loan is that the collateral you put up to guarantee repayment happens to be the real estate you’re using it to buy.
Let’s say you decide to buy a home for $200,000 and you have enough money in the bank so you can pay 20% of the purchase price in cash ($40,000). That means you will need to borrow $160,000 to close the deal. This $160,000 loan will be your mortgage. You pay the seller $40,000 in cash, the lender gives them another $160,000 and you get the legal title to the house — with one catch. If you fail to pay off the mortgage as promised, the lender can foreclose, evict you from the premises and recoup what cash it can by having the sheriff auction off what used to be your property.
Assuming you do make your payments on time, you will eventually build up what’s called equity in your home. Your equity is basically the amount of your home’s value that belongs to you. Going back to the example above, if you have a $160,000 mortgage on a home that’s worth $200,000, you will have $40,000 in equity from the get-go.
As I mentioned earlier, there are a lot of different types of mortgages. They all have three basic components: the size of the mortgage (how much you’re borrowing), the term (how much time you have to pay it off) and the cost of (how much interest the lender is charging you).
Most mortgages have terms of either 15 or 30 years (the choice is yours), while the interest rate depends on factors like the state of the economy, your financial condition and your credit record. Right now, interest rates are at an all-time low, due in part to the global uncertainty around the Covid-19 pandemic. It’s an excellent time to buy a home (or refinance if you already own a home) and lock in a fixed-rate mortgage rate while they’re so low.
That said, we’ve also included an explainer on adjustable-rate mortgages (ARMs) below, so you know the difference between the most common types of mortgages out there.
Fixed-rate mortgages are the industry’s most basic mortgage product. Most have a term of either 15 years or 30 years, with 30 being the most popular.
The defining characteristic of the fixed-rate mortgage is that its interest rate is fixed for the entire term of the loan. In other words, however long your term is, the bank is guaranteeing that your interest rate, and therefore the size of your monthly payment, won’t change.
When mortgage interest rates are low like they are right now, locking in a rate for 15 or 30 years can be really smart. In general, this is a good, safe option, in that you’ll never lose sleep worrying that your monthly payment might go up.
30-year fixed rate mortgage
The pros: With a 30-year fixed rate, your interest rate is locked in, so you’re protected if rates rise. Your payments will be the same each month, so it’ll be easy to track and automate.
The cons: You’re locked into the same rate for 30 years, meaning, if rates fall, you’ll miss out on savings unless you refinance.
Who is it right for? If you are conservative, value peace of mind and are planning on being in your home a long time (at least seven to 10 years), a 30-year fixed rate mortgage offers the most benefits and flexibility.
15-year fixed rate mortgage
The pros: The interest rate on a 15-year mortgage is lower than that on a 30-year, and you’ll pay off your home and become debt-free in half the time. These are also easy to track, monitor and automate.
The cons: Your monthly payments will be much higher — roughly 30-45% more than they would be with a 30-year mortgage.
Who is it right for? If you’re a committed saver and plan to live in your home longer than 10 years, this is the loan for you. You can lock in a rate and be debt-free in a decade and a half.
Adjustable-rate mortgages (ARMs)
ARMs are typically 30-year mortgages with interest rates that are fixed for a set period of time that is less than the full term. The most popular variety is what is known as a 5/1 ARM, in which the rate you get at the start is fixed only for the first five years. After that, it’s adjusted once a year (this is what the “1” in “5/1” means), based on the movement of a key economic indicator that will be specified in your mortgage agreement.
7/1 and 10/1 ARMs, in which the interest rate is fixed for an initial period of seven and 10 years, are also popular. And then there are short-term ARMs, with rates that are locked for periods as short as one month.
The advantage of ARMs is that they generally offer lower interest rates than comparable fixed-rate mortgages — at least for that initial period. The disadvantage is that once the initial period ends, all bets are off: If interest rates rise, your monthly payment will go up along with them.
With ARMs, it’s important to know what’s called the margin on your loan. Your terms may sound something like this: Your rate will be 5% for five years and then it will adjust to 2.5% over the treasury index. This 2.5% is the margin.
Again, right now, it’s smart to go with a fixed-rate mortgage, since you can lock in such low interest rates. (As of September 2020, the average interest rate on a 30-year fixed-rate mortgage and a 5/1 ARM are about the same.) But it’s good to know what your options are, especially if rates start to increase in the future.
Short-term ARMS (three years or less)
The pros: You generally get a substantial break on the interest rate at first. So, initially, your monthly payment tends to be much less with this mortgage than with other loans.
The cons: If interest rates go up quickly, you could find yourself having trouble making payments. There are no guarantees with ARMs, so if you don’t like uncertainty or can’t count on having more money to spend on your mortgage than you have right now, this is not the right mortgage for you.
Who is it right for? ARMs can be a great deal if rates stay low. They make sense for homebuyers who want to keep their monthly payments as small as possible, can handle risk and don’t expect to live in the house more than a few years.
Intermediate ARMS (5/1, 7/1 or 10/1)
The pros: Interest rates are relatively low.
The cons: Your rate is locked only for a limited time. After that, if rates have risen, your monthly mortgage payment will rise.
Who is it right for? Intermediate ARMs are great for homebuyers who are looking for lower monthly payments and are either not planning on keeping the property very long or expecting rates to rise for a while but eventually fall.
For more advice on the homebuying process, check out my FREE First-Time Homebuyer Challenge. You’ll learn how to build an emergency account, get your credit score up (and protect it), qualify for a mortgage loan, tackle credit card debt and work with a realtor. It includes five days of video coaching, mentoring and great tools to help you take action. Click here to get access.