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Defining Mortgage Rates

A fixed mortgage or an ARM? And if an ARM, what kind? And what about so-called "flexible" mortgages?

Unfortunately, there is no single answer to the type of mortgage that is right for you. "It depends" is as close as you will come to a definitive answer. For example, the length of time you intend to spend in your new house has a huge bearing on what type of loan you agree to. But whatever your situation, you need to understand the various types of interest rates so you won't be blindsided by those monthly payments. (For information on specific mortgage types, see Understanding Types of Mortgages and Home Loans.)

Common interest rates include:

Fixed rate: The monthly payment does not change over the life of the loan in a fixed rate mortgage. For example, if you have a 30-year loan, it will be paid in full after 360 fixed monthly payments. Your payments will not fluctuate.

Adjustable rate: An Adjustable Rate Mortgage (ARM) uses an interest rate that fluctuates with an indexed rate plus a set margin; therefore the monthly payment may increase or decrease over the life of the loan.

Hybrid ARM: Hybrid ARMs have set adjustment periods, which means the interest rate changes on a predetermined schedule. For example:

• 3/1 year: Monthly payment remains fixed for 3 years and then adjusts every year thereafter
• 5/1 year: Monthly payment remains fixed for 5 years and then adjusts every year thereafter
• 7/1 year: Monthly payment remains fixed for 7 years and then adjusts every year thereafter

Flexible option ARM: The interest rate in a flexible ARM is calculated daily and changes with each monthly payment. There is a change cap limiting how much the payments can change within a year. The borrowers choose from a menu of options to pay what they want monthly.

Interest-only: For a period of time, usually 5 or 10 years, monthly payments cover only the interest on the loan. After that period, the monthly payment adjusts to include paying back the principal as well. As many borrowers can testify, the danger with this type of loan is that the property becomes devalued during the interest-only period and the owner owes more on principal than the house is worth.

Capped rate: In this type of mortgage, a lender guarantees the interest rate will never rise above a set amount for a period of time, so there is a certain amount of security for the borrower. The good news for the borrower is that if the rate decreases during that period, so do the payments.