The first question to ask yourself when deciding on a loan type is: how long do you think you will own this property?
- Review the four primary loan types.
- Consider your needs and risk profile.
The first question to ask yourself when deciding on a loan type is: how long do you think you will own this property?
These guidelines will apply to borrowers with typical loan scenarios. Out of the 80+ lenders with whom we work, many have niche loan products for borrowers who have unusual situations.
There are four primary loan types:
Each of these loan types is available with the option of making an interest only payment; some may have the option of a prepayment penalty.
This is the first question to ask when deciding on a type of loan. If you are reasonably certain of the answer, simply matching the fixed period of your loan term to that length of time using a hybrid mortgage is generally the best way to go. Normally, the longer the fixed term on a hybrid loan, the higher the interest rate. A hybrid fixed for 5 years will have a lower rate than one fixed for 7 years, and a hybrid fixed for 7 years will have a lower rate than one fixed for 10 years.
The only way to know which type of mortgage is the best for you is with a crystal ball. If interest rates drop and stay down for a long period of time, you will be better off with an adjustable; if the opposite happens you will be better off with a hybrid or a fixed.
If you are not sure how long you will be in your home, or if you believe that you will be in it for a long time, choosing among fixed rate loans, ARMs or hybrids has two components: practical considerations and your risk profile.
There are a number of practical reasons why you may need an adjustable rate mortgage or a hybrid. Most of these loans allow you to qualify at a lower interest rate than the prevailing fixed rate. This may be essential to be approved for the loan amount you need to purchase the house you want, or to refinance your current mortgage. Another practical consideration is current cash flow—you may want the short-term advantage of the lower monthly payment that you get with an arm because you need extra money now for whatever reason—taking time off from work, expanding a business, or making an investment. An impending liquidity event—for example an IPO, a large bonus, or an inheritance—may be another reason to opt for an ARM.
If you are not very certain about how long you will be in your home, and if you don’t have a practical need for a hybrid or an ARM, the most important factor in determining which type of loan is better becomes your willingness to accept the risk of a potentially higher mortgage payment in the future in return for a lower initial interest rate and payment. If you opt for an ARM your payment might be much lower initially than the payment on a 30 year fixed, but the payment might be much higher two or three years in the future. Choosing a hybrid loan is less risky, especially if you choose one with an interest rate and a payment fixed for 7 or 10 years. Your worst-case scenario with an ARM or hybrid is simple to quantify—if the loan goes to its life cap, what will your monthly payment be? Although you may believe it is unlikely to occur, are you willing to take the risk of being locked into an ARM through a long period of high interest rates? You may want to read What are interest rates going to do in the future?
If you are a risk taker and are willing to pay the price if rates go up, then the ARM may be right for you. If you don’t want to gamble with your home mortgage or know that if the adjustable went to its life cap you would be financially squeezed, stay with the hybrid or the fixed rate loan.
Remember, if you get a hybrid or a fixed rate loan and interest rates do fall, you can always refinance. Lender rebates have made it possible to refinance with most of the closing costs paid by the lender.
