As a first time home buyer, you need to understand the mechanics of a good mortgage. If you’ve been looking for an article that helps with this, you have come to the right place.

In this article we’ll discuss the mortgage process and how you can decide which product is best for you. There will be two primary things you will learn. First we will look at how mortgages work and then discuss the pros and cons of fixed rate mortgages versus the adjustable mortgage.

Understanding How Mortgages Work

It’s kind of funny how people look at mortgages. We say “I need to get a mortgage from the bank”. Actually you cannot get a mortgage, you will give a mortgage or pledge a mortgage to a lender. Does this mean you are the bank or what?? Not really, it’s matter of understanding the proper terminology.

When you buy a home, you sign a ton of documents. I often said when I was closing mortgages that a few trees were sacrificed for this since it involves so much paper work. There are two very important documents in this stack of papers. One is the “note” and the other is the “mortgage”.

The note is your IOU which states you owe a debt to the lender and promise to repay. The mortgage is the legal document that secures the note.

So you want to look at it this way: When a bank loans you money to buy a home, you “give” or “pledge” a mortgage to the bank. The bank will hold this mortgage as a legal claim in case you default and stop making payments on the note. It’s kind of a guarantee you will live up to the terms on the note you signed. So in other words, if you don’t pay, you don’t stay. The bank will force a foreclosure on you and take back the house.

Pros and Cons of Fixed Rate Mortgages

In the mortgage industry, the fixed rate loan has been labeled as the “vanilla loan” because there is nothing fancy about it. It has a set rate of interest and you will know what your principal and interest payment will be for the entire term of the mortgage. There are 10, 15, 20 and 30 year fixed rate mortgages out there.

The biggest advantage of the fixed rate loan is the fact you have permanently locked into a mortgage payment that you can count on never changing. This helps to eliminate any surprises for later, like when interest rates go up. If that happens, your payment stays the same.

Personally, I believe the fixed rate mortgage is the best choice for first time home buyers. You can budget your payment this way and plan for your future. Keep in mind I did not talk about taxes and insurance which are the other part of your payment. If you used the minimum down payment (3.5% for FHA) then you will be forced to escrow your taxes and home owners insurance. This part of your payment can fluctuate each year.

Adjustable Rate Mortgages – Are They Right For You?

Unlike their cousin the fixed rate mortgage, the name of this loan product implies that it features a variable interest rate. These rates change or “reset” over time. Because of this, the principal and interest portion of your mortgage will change according to the terms of the note.

There is a whole variety of these ARMS (adjustable rate mortgages) out there. These ARM loans can adjust monthly, semi-annually or yearly. Banks have gotten real creative with these products.

Since the banks know that people like the security of a fixed rate mortgage, they make these ARMS look like one by setting the terms for them to reset the first time say 3, 5, 7 or 10 years after you get the mortgage. So a person could get used to the payment and then 3 years from now it goes up because of the way this loan is calculated.

The adjustable rate mortgage is based on a financial instrument like the 10, 15 or 30 year mortgage bond. In recent years, banks have based the ARM loan on the LIBOR index. This allows for more frequent changes since it moves up and down with market fluctuations. The LIBOR is a matter for a whole different article.

Conclusion of the Matter

The ARM loan works best for people who do not plan to own the house for a long period of time. Maybe you know that that your job may relocate you in 5 years. So an ARM loan with a 5 year period before it resets may be a good idea.

However, most first time home buyers are looking down the road more than 5 years. The fixed rate mortgage is the best idea for budgeting and just having a peace of mind. You can sleep well at night knowing your house payment is constant.

So, now you understand what a mortgage really is, and you have also learned the difference between a fixed rate mortgage and an ARM.