How to Choose a Type of Mortgage

Once you’ve determined how big a mortgage you can afford, your next steps (unless you’ve qualified for a government loan or another special situation) should be to choose your:

1. Type of mortgage: Fixed-rate or adjustable-rate
2. Term of mortgage: 15 or 30 years

Fixed-Rate vs. Adjustable-Rate Mortgages

The most important factor in your decision between an ARM or a fixed-rate mortgage is how long you plan to live in the property.

• If you plan to live in the property for more than 5–7 years: A fixed-rate mortgage is usually the better choice. Since most ARMs start adjusting after 5–7 years, having a fixed-rate mortgage will protect you from the prospect of paying higher rates.
• If you plan to sell within 5–7 years: You can benefit from the low initial rates of an ARM without facing the risk of adjusting interest rates if you sell the property before the initial fixed term of the mortgage ends. If you choose an ARM for this reason, though, make sure that you really will sell before the fixed term ends.

The Affordability Trap of ARMs

Home buyers often look to ARMs as a way to make a dream home “affordable.” They choose an ARM because they’re confident they can make the ARM’s lower monthly payments and ignore the prospect of being unable to afford the higher payments that might ensue when the ARM’s fixed-rate period ends. To avoid this trap, choose an ARM only if you’re certain you can afford the payments if they increase to the fullest possible amount after your rate adjusts.

15-Year vs. 30-Year Mortgages

The length of a mortgage’s term affects both the total cost of the mortgage and the size of the monthly payments.

• Longer mortgage terms mean lower monthly payments: Because they stretch out the mortgage over more time, longer-term mortgages offer lower monthly payments than shorter-term mortgages.
• Shorter mortgage terms result in lower total costs: Because they generate less total interest over time, shorter-term mortgages offer lower total cost than longer-term mortgages.

The table below shows monthly payments and total costs for two mortgages with the same principal ($100,000) and interest rate (6%), but with 15- and 30-year terms.

Which Term Should You Choose?

Whether you should choose a longer- or shorter-term mortgage depends on your particular financial situation. If you can definitely handle the higher monthly payments of a shorter-term mortgage, that’s probably the better way to go. If you can’t (and many people can’t), a longer-term mortgage is the better choice.