There are two primary types of mortgages: fixed and adjustable.
Fixed-Rate Mortgage
This is the plain-vanilla loan that most people think of when considering a mortgage. The fixed rate mortgage is an extremely stable choice. With this type of mortgage you pay a certain interest rate over the life of the mortgage. You are protected from rising interest rates, and it makes budgeting for the future very easy. With a fixed-rate mortgage, your monthly payment will remain the same over the life of the loan.
Fixed rate mortgages are available with terms of 10, 15, 20 and 30 years with the 15-year term becoming more and more popular. The advantage of a 15-year over a 30-year mortgage is that while your payments are higher, your principal balance will be paid off sooner, saving you substantial money in interest payments over the life of your loan. Also, the rates are almost always lower with a 15-year loan. If you're looking for a mortgage with payments that will remain unchanged over its term, or if you plan to stay in your home for a long period of time, a fixed rate mortgage is probably right for you. With a fixed rate mortgage, the interest rate you close with won't change (and your payments of principal and interest remain the same each month) until the mortgage is paid off.
But in certain types of economies, the interest rate for a fixed rate mortgage is considerably higher than the initial interest rate of other mortgage options. Once your rate is set, it does not change and falling interest rates will not affect what you pay unless you refinance your mortgage.
Adjustable Rate Mortgages (ARMs)
An adjustable rate mortgage is considerably different from a fixed rate mortgage. ARMs were first introduced in the early 1980s. They were created to provide affordable mortgage financing in a changing economic environment.
An ARM is a mortgage where the interest rate changes at preset intervals (defined in the mortgage), according to rising and falling interest rates and the economy in general. This "reset frequency" can be monthly, quarterly, semi-annually, annually or just about anything the lender wants. Quarterly resets are probably the most common.
To control how much and how quickly an interest rate can change for an ARM, something called "caps" are defined in ARM mortgages. Caps can be used to restrict the maximum amount the interest rate on an ARM can increase in any given year (annual cap) and the amount they can increase during the life of the mortgage (lifetime caps). Other cap frequencies can be used along with "floors" which restrict how much and how quickly a rate can decrease. You need to work with your lender to clearly understand what caps, floors and reset frequencies are applicable to the mortgage you are evaluating.
Another type of ARM is the convertible ARM which allows you to convert to a fixed rate mortgage after a specified period of time has elapsed. For instance, you could get a one-year ARM with the option to convert to the prevailing fixed interest rate at any time after the first through the fifth adjustment period. Convertible ARMs offer the ability to take advantage of lower rates initially and have possible savings, and the option to convert to a fixed rate loan later on when you may be able to better afford it. Depending on your financial needs, you might find this option the best of both worlds.
The benefits of getting an ARM over a Fixed-Rate mortgage is that the interest rates are usually lower. This is the case when lenders are offering "teaser" rates for an ARM's first year, which are many times 1% or more below the market rate. The downside of getting an ARM is that you don't know how much your mortgage payments will be over the life of the mortgage. It all comes down to how much risk you are willing to assume. Another consideration is how long you expect to be in your home. The shorter the duration in your home, the less interest rate fluctuations you will likely experience with the ARM. Some people have saved thousands by getting an ARM, while others have been unable to make their mortgage payment when rates moved upward.