Despite the fixed rate, you're not actually paying the same amount of interest each month. That's because in the early years of your loan when the principal is at its largest, you technically owe more interest. But the lender calculates your payment so it's the same amount each month (the loan is "amortized"). The way amortization shakes out, the interest you owe makes up a greater portion of your early monthly payments. As you gradually start to reduce the principal, less interest accrues, and so more of your payment goes to reducing principal. That's because in the early years of your loan when the principal is at its largest, you technically owe more interest. But the lender calculates your payment so it's the same amount each month (the loan is "amortized"). The way amortization shakes out, the interest you owe makes up a greater portion of your early monthly payments. As you gradually start to reduce the principal, less interest accrues, and so more of your payment goes to reducing principal.

Beyond buyers who crave predictability, fixed rate mortgages are good for those who want to stay put long term, particularly if interest rates are low. Even if interest rates go sky-high, you'll have a fixed rate you can live with. You pay a premium for this stability, because fixed rate mortgages usually have higher starting interest rates than ARMs. That protects lenders who are stuck giving you a nice low rate for the full term of the loan, even when interest rates increase and other buyers are paying them more.

A drawback of fixed rate mortgages is that they aren't usually assumable. That means that if someone buys your house before it's paid off, taking over your mortgage payments isn't an option. The buyer will have to get a new mortgage, choosing from what's then available. Most buyers expect this, but assumable mortgages can, in certain markets, make your house more saleable.

The Gold Standard: 30-Year Fixed

Until pretty recently, the ultimate in predictability and stability was the 30-year fixed rate loan. It allows borrowers to finance their home purchase at a fixed interest rate and pay it off over a full 30 years. These loans make sense for people who plan to live in their homes for several years. (Of course, you don't have to stay in your house that long.) The Saver's Special: 15-Year Fixed

If you're extremely disciplined and can afford it, you might consider a shorter-term fixed loan, most typically a 15-year mortgage. Like any fixed rate mortgage, these have stable interest rates and predictable terms. By paying more each month, you ultimately pay less interest overall. As an added plus, you probably get a relatively low interest rate.

You can see why they're not as popular, however: Paying money back faster means committing yourself to relatively high monthly payments.

EXAMPLE: Adina wants to take out a loan for $150,000 to buy a new condo. She can choose between a 30-year, fixed rate mortgage with a 6.25% interest rate, and a 15-year fixed rate mortgage with a 6% interest rate. Adina wants to take out a loan for $150,000 to buy a new condo. She can choose between a 30-year, fixed rate mortgage with a 6.25% interest rate, and a 15-year fixed rate mortgage with a 6% interest rate.

With the first loan, Adina will have a monthly principal and interest payment of around $924. After 30 years, she'll have paid about $183,000 in interest. If Adina takes the second loan, she'll have a significantly higher principal and interest payment, approximately $1,266 each month. However, at the end of 15 years, she'll have paid off her mortgage and spent about $78,000 on interest ($105,000 less than with the 30-year mortgage).

Shorter-term fixed rate loans free your income for other purposes earlier than longer-term mortgages do. If you know you're going to want money for something else-for example, to pay college tuition, purchase a second home, or retire-such a loan can act as a serious forced savings plan.

That doesn't necessarily make it the most financially savvy option, however-especially not if you can make money by investing elsewhere or reducing your higher-interest debt (like on credit cards). For example, if you commit to a 15-year mortgage instead of contributing your money to a retirement plan, you could end up house-rich but cash-poor-with a place to retire in, but not enough money to do so. A better way to accomplish your savings goals might be to take out a longer-term loan and contribute the cash you've freed up to a 401(k) or IRA.

As a compromise, some people take out a 30-year fixed rate loan but then make higher-than-required monthly payments to the loan principal. The more principal you pay, the less interest accrues, so if you make early payments, you also end up paying less interest overall. While this strategy won't save you quite as much money as a shorter-term fixed rate loan would (since your interest rate will probably be a little higher), you face less future risk. If someday you can't afford to make more than the minimum payment, you're not locked in.

TIP.

Put it to principal. If you decide to make a prepayment, write on the check that the payment is to be applied toward principal. Otherwise, the lender might apply it toward the next payment that's due, which will defeat your purpose. If you decide to make a prepayment, write on the check that the payment is to be applied toward principal. Otherwise, the lender might apply it toward the next payment that's due, which will defeat your purpose.

The Endless Loan: 40-Year Fixed

If you're interested in the stability of a fixed rate loan but won't qualify for a 30-year term, you may be drawn to another option: the 40-year loan. These loans have become less available in recent years, but if you're able to find one, it can offer a tempting combination of relatively low monthly payments and a stable interest rate.

However, the 40-year fixed is expensive over the long term. Since you're borrowing the money for a longer period of time, you're going to pay a lot more total interest, so you won't see a huge reduction in your monthly payment.

EXAMPLE: Sarah and Jorge plan to borrow $300,000 to buy a home. They're considering two options: a 30-year, fixed rate mortgage at 6.5% and a 40-year fixed rate mortgage, also at 6.5%. Sarah and Jorge plan to borrow $300,000 to buy a home. They're considering two options: a 30-year, fixed rate mortgage at 6.5% and a 40-year fixed rate mortgage, also at 6.5%.

If Sarah and Jorge get the 30-year loan, their monthly principal and interest payments will be about $1,896 and they'll pay $382,637 in interest over the life of the loan. If they get the 40-year loan, they'll pay $1,756 per month ($140 less) in principal and interest-but their total interest payments after 40 years will be $543,058-a whopping $160,421 more in total interest.

Another drawback of 40-year fixed rate loans is that most have a higher interest rate than would be offered on a 30-year loan, so the difference in monthly payments is even less. Finally, remember that taking out a 40-year loan means that you'll have debt hanging over your head for 40 years (assuming you stay put and don't refinance or prepay). Depending on your age, that could take you well into retirement.

CHECK IT OUT.

Tally up how your 401(k) contributions will grow between now and retirement: Go to Go to www.bankrate.com, click "Calculators," then under "Investment Calculators," click "401(k) planning."

The Poser: Balloon Loans

At first glance, balloon loans look pretty attractive. Their interest rate usually starts below the market rate on a 30-year fixed rate mortgage. You make payments for a fixed period of time-usually somewhere between three and ten years. However, your monthly payments are calculated as if you were paying the same amount each month for 30 years, which keeps them low. (The technical way to say this is that the loan is amortized over a 30-year period.) However, at the end of the fixed period, you owe the entire loan balance, then and there. This isn't necessarily a problem, since you may be able to refinance with another lender, assuming interest rates are favorable at the time and that you have sufficient equity.

But it's difficult to bank on that happening, which is one reason these loans aren't as readily available as they were a few years ago. The balloon payment could become a problem if you find yourself unable to qualify for another loan because the value of your house has dropped (hopefully temporarily), your financial circumstances change, or you have some credit snafus in the meantime. Unlike an ARM, you won't even have the option of continuing to make payments at a higher rate. A better alternative is to get a hybrid loan, discussed below.

Adjustable Rate Mortgages

As the name implies, the interest rate on an adjustable rate mortgage ("ARM") can fluctuate during the loan term-and no one can predict with certainty where interest rates will go. For buyers who aren't put off by this risk, or see buying their first home as a short-term stepping stone, the ARM may be an attractive option.

The relatively low initial interest rates are certainly eye-catching and have made ARMs a favorite among new buyers.

But what about those fluctuating interest rates? They're definitely the main risk factor in an ARM. After the starter rate runs out, the rate adjusts periodically at an agreed-upon term. This term (called the adjustment period adjustment period) may vary from one month to several years. Buyers in the last several years were lured by lenders offering ridiculously low initial interest rates, only to find their payments completely unaffordable once the rate adjusted (sometimes, as quickly as a month later). This contributed to the very problems in the mortgage market that make lenders more careful about offering ARMs today.

When you're looking at the loan description for an ARM, check out a number called an index index: The lender will adjust your rate to equal the index plus an extra amount, so that it makes a profit. That bit of profit, calculated as either a set amount or percentage, is called a margin margin.

Luckily, your lender doesn't get to invent the index. It will draw on a particular published, market-driven number. Common indexes include the London Interbank Offered Rate (LIBOR), the 11th Federal Home Loan Bank District Cost of Funds (COFI), U.S. Treasury Bills, or Certificates of Deposit (CDs). The LIBOR is usually the most volatile, meaning it jumps up or down quickly and dramatically, while the COFI is less volatile. Also, an index that averages rates over the long term (a year or every six months) is preferable to one that moves up and down based on the weekly "spot" rate.

Another number to seek out when comparing ARMs is the life-of-the-loan cap life-of-the-loan cap. This is a maximum on the ARM's total interest rate, no matter how high the index rises. The lender usually allows a well-padded 5%-6% above the starting interest rate, which can affect your monthly payment by hundreds or even thousands of dollars. Still, it's far better than getting an ARM without a life-of-the-loan cap-that's downright dangerous.

In addition to a life-of-the-loan cap, most ARMs limit how much your interest rate can increase at any adjustment period. This number is called the periodic cap periodic cap. It's also a floor, limiting the amount the rate can decrease at one time. Look for an ARM that doesn't change by more than 2%-3% at each adjustment period. Otherwise, your monthly payment could shoot up very rapidly.

EXAMPLE: On a $200,000 loan, you're choosing between a 30-year, fixed rate mortgage with a 5.85% interest rate and an ARM with an initial 5.5% rate. The life-of-the-loan cap on the ARM is 11.5%. Your monthly principal and interest payment on the fixed rate loan would be approximately $1,180 and never increase above that. Your monthly payment on the ARM would start at approximately $1,136. However, if your interest rate adjusts to the maximum 11.5%, your payment could go as high as $1,980-about $700 more. On a $200,000 loan, you're choosing between a 30-year, fixed rate mortgage with a 5.85% interest rate and an ARM with an initial 5.5% rate. The life-of-the-loan cap on the ARM is 11.5%. Your monthly principal and interest payment on the fixed rate loan would be approximately $1,180 and never increase above that. Your monthly payment on the ARM would start at approximately $1,136. However, if your interest rate adjusts to the maximum 11.5%, your payment could go as high as $1,980-about $700 more.

Traditional ARMs

The traditional ARM works like this: The loan starts out at a below-market interest rate, called a teaser rate teaser rate. This rate adjusts frequently, as frequently as every month in some cases. As we've seen, that adjustment can make a big difference in your monthly payment.

A traditional ARM is rarely a good financing strategy. Many people who choose it can't really afford the home that they're hoping to buy. If you can only afford the monthly payment in the first few months when the interest rate is artificially low, what are you going to do when it goes up?

The exception is if you expect a significant increase in your income very soon, or you're in line for some other form of income, such as an inheritance or gift. If so, a traditional ARM might be a bridge until you can qualify for a loan with better terms or pay off your property entirely.

CHECK IT OUT.

Interested in a traditional ARM? You'll need to know what maximum amounts you could owe each month. Your mortgage broker should be able to calculate this for you, or you can use an online ARM payment calculator, like the ones at You'll need to know what maximum amounts you could owe each month. Your mortgage broker should be able to calculate this for you, or you can use an online ARM payment calculator, like the ones at www.nolo.com/calculators, www.interest.com, or www.dinkytown.net.

Interest-Only ARMs

Another type of ARM is the interest-only variety: once very common, but increasingly difficult to find. (Although interest-only loans don't have have to be ARMs, they usually are.) This is, at least at the beginning, just what it sounds like: You start out paying only the interest that accrues on the loan principal, making for very low monthly payments. The downside is that you don't reduce the amount you borrowed (there's no "P" in your PITI). And of course, you have to start paying off the principal some day-usually between three and ten years later. At that time, you'll either have to pay much higher monthly payments or, with a balloon loan, pay the whole thing off. to be ARMs, they usually are.) This is, at least at the beginning, just what it sounds like: You start out paying only the interest that accrues on the loan principal, making for very low monthly payments. The downside is that you don't reduce the amount you borrowed (there's no "P" in your PITI). And of course, you have to start paying off the principal some day-usually between three and ten years later. At that time, you'll either have to pay much higher monthly payments or, with a balloon loan, pay the whole thing off.

Interest-only loans are attractive when home prices are going up fast, with first-time buyers squeezing into the market. These buyers hope to make the low monthly payments long enough for their house to rise in value, then either sell without having to pay off the loan principal or refinance on better terms.

But as the recent turn in most real estate markets shows us, this can be a dangerous strategy. Such buyers pin all their hopes on the value of the property increasing, especially because interest-only payments don't increase their equity. If the value of the property drops, the buyer could face a serious loss, particularly if forced to sell (maybe due to a job transfer) or after a change in the terms of the loan (an adjustment to the interest rate). And the buyer would remain responsible for paying the difference between the amount the house can be sold for and the remaining loan balance.

Buyers who pay down principal are in a much better position to weather unexpected drops in home prices. Even if forced to sell, they'll owe less than their interest-only counterparts, because they'll have built up some equity by reducing principal.

Option ARMs

The risk of an interest-only loan is surpassed only by the risk of an option ARM. Option ARMs, surprise, surprise, give you the option option to pay an amount you want to each month. There are four options: (1) an accelerated payment that will help you pay off the loan over a shorter period than the actual loan term; (2) a payment of principal plus interest, as if you were paying off a normal, regularly amortized loan; (3) an interest-only payment; and (4) a payment that can be even less than interest-only (it's a maximum payment, called a "payment cap," based on your initial interest rate). to pay an amount you want to each month. There are four options: (1) an accelerated payment that will help you pay off the loan over a shorter period than the actual loan term; (2) a payment of principal plus interest, as if you were paying off a normal, regularly amortized loan; (3) an interest-only payment; and (4) a payment that can be even less than interest-only (it's a maximum payment, called a "payment cap," based on your initial interest rate).

You can literally choose which payment to make each month-you don't have to decide until you receive your bill. Since the loan is normally an ARM, the interest rate can fluctuate at each adjustment period (often month to month). If your interest rate has adjusted upward, more interest has accrued, and so each payment option will be a bigger dollar amount, except the fourth payment, since it's locked according to the initial rate.

That last "locked" payment may sound appealing, but it presents a major problem: Your loan can negatively amortize, meaning your payment won't cover the interest that accrued that month. That unpaid interest is added to the loan principal, and you're further in the hole than when you started.

If you're planning on living in your first home for less than ten years, a hybrid ARM can give you stability without the relatively high interest that you'd pay for a "real" fixed rate mortgage. However, if you stay in your home after the expiration of the fixed term, your interest rate may go up significantly.

To deal with negative amortization, some option ARMs require that the loan be "recast" every five years or so (or earlier if you reach a negative amortization limit imposed by the terms of the loan). That means that the lender will use your new principal balance-which might be higher than it was years before-to calculate a new payment schedule to dig you out of the hole.

Judging an ARM Beauty Contest If you decide to get an ARM, here's a summary of the features to examine:* Initial interest rate. Initial interest rate. This should be significantly less than is available on a fixed rate mortgage, to balance the added risk of rate increases. This should be significantly less than is available on a fixed rate mortgage, to balance the added risk of rate increases.* Adjustment period. Adjustment period. Look for annual or biannual (not monthly) adjustment periods. Look for annual or biannual (not monthly) adjustment periods.* Index. Index. A slow-changing index (such as the COFI) is preferable to a rapidly changing, volatile one. A slow-changing index (such as the COFI) is preferable to a rapidly changing, volatile one.* Life-of-the-loan cap. Life-of-the-loan cap. Don't agree to pay a maximum interest rate greater than 6% above the initial rate. Don't agree to pay a maximum interest rate greater than 6% above the initial rate.* Periodic cap. Periodic cap. The interest rate should change only a reasonable amount at each adjustment period; 2% is about right on a one-year ARM. The interest rate should change only a reasonable amount at each adjustment period; 2% is about right on a one-year ARM.* Low margin. Low margin. The margin should be as low as possible; around 2.5% on a six-month ARM or 2.75% on a one-year ARM. The margin should be as low as possible; around 2.5% on a six-month ARM or 2.75% on a one-year ARM.* No prepayment penalty. No prepayment penalty. You don't want to be charged extra for making early payments or refinancing. You don't want to be charged extra for making early payments or refinancing.* No negative amortization. No negative amortization. You don't ever want to owe more principal than you started with; a good reason to avoid option ARMs. You don't ever want to owe more principal than you started with; a good reason to avoid option ARMs.* Assumability. Assumability. ARMs are sometimes assumable, which means that when you sell the house, the next buyer can take over your loan. If interest rates are high then, this can be an incentive to prospective buyers. ARMs are sometimes assumable, which means that when you sell the house, the next buyer can take over your loan. If interest rates are high then, this can be an incentive to prospective buyers.

Once the loan is properly amortized, you can repeat the same cycle over again: You can again negatively amortize your loan, and another recast will help you catch up. While this helps you limit negative amortization over the long haul, it doesn't eliminate it entirely, and recasting prevents the very thing you're probably seeking-low monthly payments.

Since the interest rate and minimum payment on an option ARM start out very low, it sounds like a good idea for someone who is disciplined enough to pay the accelerated or principal-plus-interest payment. But if you're that disciplined, would the option ARM appeal to you? Probably not. You'd recognize that you'd be better off, long term, with a more stable loan. No wonder fewer lenders today offer option ARMs-they've had too many borrowers who chose them end up in financial distress.

Hybrid Loans

Hybrid loans, like hybrid cars, can save you money. While hybrid cars do it by eating less gas, hybrid loans do it through lower interest rates. They're a safer and more realistic option for many first-time buyers who want to break into the market but don't plan to be in their first homes forever.

Hybrids work like this: For a set period of time, you pay interest at a fixed rate-usually, below the market rate on a regular fixed mortgage-and after that, the rate becomes adjustable. The fixed-rate term is usually three, five, seven, or ten years. The frequency of the adjustment varies, but it's usually every six months or one year. (A "5/1," for example, means that the rate is fixed for five years, then adjusts every year.) That means you want to know how long you'll be in your home before signing up for a hybrid ARM. If you're not sure or you want to maximize flexibility and reduce risk, select a hybrid with a longer fixed-rate term (such as ten years). You might have to pay a slightly higher interest rate, but you'll save the cost of a refinance, if you realize at the end of the shorter term that you're not ready to go. And you'll save yourself the stress of trying to predict where you-and interest rates-are going to be in ten years.

Two-Step Loans

A two-step loan is essentially a hybrid loan with only one adjustment. During the first "step" of the mortgage-typically a period of five or seven years-the loan has a fixed rate that's usually below comparable fixed rate mortgages. Then the rate adjusts to a newer fixed rate, but unlike a hybrid, it doesn't keep changing every six months or year. The second step's interest rate will be set based on the index at the time of the adjustment plus a margin.

If you see a loan referred to as 5/25 or 7/23, that may indicate that it's a two-step loan. The first number is the number of years of the first "step," and the second number indicates the length in years of the second "step." Look closely, though, as some balloon mortgages are similarly labeled.

Of course, if you get a two-step mortgage, make sure you'll be able to afford the second step. Since it's impossible to know future interest rates, you may find that it makes more sense to refinance when the first step ends.

Getting Your Cash Together: Common Down Payment and Financing Strategies

Talk to anyone who bought their first home in the last few years, and you may hear, "We put zero down!" or "We got two mortgages so we could avoid private mortgage insurance!" Many buyers employed some creative down-payment strategies to help get into their first homes, and lenders obliged.

But with the market having done a huge turnaround, these methods have nearly dropped off the map. To make sure you understand the full range of possibilities, however, we'll explain all the strategies here, from the traditional to the more creative.

The Traditional: 80/20