Sorting Through Mortgage Options

It seems like everyone's talking about the difficulty getting mortgages, and how volatile adjustable-rate mortgages can be. But if you're a disciplined investor, you can sift through the warnings to find the right loan for you.

Evaluating mortgages is about as straightforward as sorting your laundry. Sure, the navy blue shorts go with the black t-shirt, and the white sweatshirt goes with the white socks. But where do you put that white shirt with the black stripes? Likewise, how do you classify an interest-only, fixed-rate-mortgage">fixed rate mortgage or a hybrid ARM?

Mortgages are confusing enough on their own, even if you aren't dealing with all the negative talk and misinformation floating around out there in the market. For your own sanity, it's time to tune out the background noise and deal with the facts. Let's start with the two basic mortgage types:

Fixed-rate mortgage (FRM): The FRM is considered the safest mortgage because the interest rate remains unchanged until maturity. FRMs are usually amortized over 30 years, but they're also available with 15- or 20-year terms.

Adjustable-rate mortgage (ARM): An ARM's interest rate is tied to a variable index, which moves up or down on the strength of the economy. If you're considering an ARM, understand what the interest rate caps are, and the frequency of adjustments.

Considerations

Hybrid ARMs start out with a fixed rate that remains in effect for a specified time period, usually three, five, or seven years. The loan then converts to an adjustable structure, which often means a payment increase.

Another variation is the Option ARM, which allows you to choose your payment amount from several options each month. The minimum option is actually less than the month's accrued interest. Be careful though: any unpaid interest will be added into your loan, thus increasing your balance.

Interest-Only

Both ARMs and FRMs can be interest-only. Under this structure, your minimum monthly payment obligation for the first several years of the loan would be just accrued interest. All principal payments would be deferred until after the interest-only period expires, which could be three, five or even 10 years. There are two notable trade-offs for the luxury of that lower payment. You wouldn't build equity unless the home increases in value, and your payment would go up significantly once the interest-only period expires.

ARMs and Variations

Whether you're interested in a traditional or unconventional mortgage, it's vital that you understand both your payment obligations at all stages of the loan, and how the loan balance reduces over time

If you choose lower payments now, you're also choosing slower build-up of equity and higher payments later. Things can get dicey if you do this, because you don't know if you'll be able to afford the higher payments down the road. You don't want to put yourself in a position of having to refinance, because you don't know the future direction of rates. Mixing up the laundry is one thing, but mixing up your mortgage could leave you with a shrunken money supply and hard-to-remove stains on your credit rating.