There are literally hundreds of different types of mortgage products, designed by financial institutions to offer a greater degree of creativity, affordability and flexibility. But most of these products can be divided into two basic groups when it comes to interest rates: adjustable and fixed. While some armchair analysts will steadfastly recommend one over the other, in reality, whether you choose an adjustable or fixed rate mortgage depends on a lot of factors, including your personal credit rating, and even larger economic factors such as the current policy of the Federal Reserve.
Simply put, a fixed rate mortgage is just that, it gives you a mortgage with a set interest rate for the duration of the loan. An adjustable rate mortgage has an interest rate that moves up and down with the prevailing interest rate. But what if the interest rate doubles five or ten years down the road? Don’t be alarmed. Almost all adjustable rate mortgages have limits, or “caps,” which impose a maximum amount that it can rise, and a maximum number of times per year the rate can be adjusted. For example, if you get an adjustable mortgage with an introductory rate of 6.5 percent, and have a two percent cap, the most interest you will ever be charged is 8.5 percent, even if the prevailing rate goes far beyond that in the future. The good news is that the adjustable mortgage goes both ways–it can also go down when and if the Fed sets the inter-bank rate lower. Another up-front advantage of the adjustable is that assuming your credit is good, a lender will often offer you a low introductory rate, which may even be lower than the current fixed rate. This is more marketing than anything else, but it still gives you an advantage. The introductory rate may be good for only six months or so, but most people have extra expenses when they first buy a home–so the lower payments you would enjoy during those first few months would give you a little extra to spend on furnishings.
A big factor in deciding which one to apply for is the current interest rate. If the current interest rate is historically low, then a fixed rate mortgage may be the best option, since it locks you in for a low rate for the long haul. If the current interest rate is higher than average, an adjustable mortgage will give you the flexibility you need to ride any future downward trends and lower your monthly payments without having to get a new mortgage.
Another factor is your credit rating. Generally speaking, the worse your credit rating is, the higher interest rate you will be charged, whether it is adjustable or fixed. If your credit is very poor, you may have few options, and the only mortgages you have at your disposal may be fixed rate mortgages set at very high rates from subprime lenders. In this situation, your best bet is to take what you can get, work on repairing your credit, and then once you have improved your credit score, see if you can qualify to refinance your home at a lower rate. You may however, be subject to a prepayment penalty, which effectively means you will be stuck with the higher rate for a specified number of years.