Fixed vs. Adjustable Rate Mortgages

There's been a lot of movement in the housing market, with prices falling in many metro areas around the country. Those of you thinking about jumping in the real estate market and buying a home, you might be able to get a good deal these days. But when figuring out what you can afford, you'll need to understand the basic difference between a fixed rate mortgage and an adjustable rate mortgage.

A fixed rate is exactly what is sounds like -- you lock in an interest rate for the duration of the loan, usually 30 years. The only way you can change the rate is if you refinance, which essentially means to get a new mortgage that will pay off your old mortgage.

An adjustable rate mortgage (ARM) will change to a different rate after a certain time period. You'll often find rates quoted for different types of ARMs, like 3/1 or 5/1. The critical piece is the first number: this is the number of years your rate is fixed before it adjusts to a new rate.

So which is better? Here's some key factors to consider:

• Length of stay: people who are very confident they plan to sell after two or three years may want to consider ARMs. Generally speaking, ARMs have lower rates, because lenders want to lure people into these products in the hope that rates might increase and the borrower accepts the new rate.
• Risk: Your risk tolerance is important to understand. There is a bit more risk to an ARM, even though the initial rate might be lower. What if you can't afford the new payment? What is you can't sell your home?
• Fees: You'll want to compare the closing fees on different mortgages in order to try and understand the true cost of the loan.
• Caps: ARMs sometimes have a cap on how much rates can adjust upward. This will give you a worst-case scenario of how much your monthly payment will be.

My personal recommendation for young borrowers: if it makes a lot of sense to buy a home, get a fixed rate mortgage unless you are sure you're going to move in 2-3 years, where an ARM might make more sense.

The mortgage market has been volatile recently, monitor mortgage rates at Bankrate and other independent sites to check the latest rates.

What's this 'credit crisis' about?

A number of you have e-mailed about the credit crisis, subprime mortgages, and other related topics asking what it all means.

A critical concept to understand that the media doesn't often talk about is the trend toward "securitization" of mortgages. In the old days, people would normally go to a local retail bank and meet with a loan officer to get a mortgage. This bank would then collect interest payments over the life of the loan. The loan officer would, in theory, carefully assess the risk of the loan in order to come up with an interest rate, because if the borrower defaulted, the bank would lose money.

That doesn't happen so much anymore. A whole new cadre of mortgage lenders (many of them now defunct) would loan money to prospective home buyers. But instead of keeping these loans on their books, they would group together these loans in a package and sell them. The borrower would make interest payments that would eventually go to the new owner of the loan.

When these lenders sold the loans, they no longer had any risk if the borrower defaulted. Perhaps this was one reason they aggressively marketed new mortgage products, that offered features like rates that would adjust after a few years or that required no downpayment. Riskier borrowers ("subprime" borrowers) were given loans, and for some reason, other financial institutions were buying these loans.

In the news, you may have heard of "write-downs" by many big banks. What this means is that the value of those loans they bought are not actually worth what they expected, since those riskier borrowers are defaulting.

The markets have been spooked by this. So what does this all mean for young borrowers? More to come in upcoming posts...