There are two major types of mortgages, those with fixed rates and adjustable rates (ARMs). Deciding between these two options (and the many derivatives of the two) can be a difficult decision. There are many things to consider, including market interest rates, mortgage length, and the amount of financial risk you're willing to take on with the mortgage.

Obviously, one of the biggest things to look at is the market interest rate. A fixed rate mortgage is preferable if market rates are low and have been declining over the past few years. Alternatively, if market rates are high and/or are expected to increase in the future, an adjustable rate mortgage may be your best option. However, it is important to calculate how much of an interest rate hike you can afford before taking an ARM. If you have very little money left over every month to make mortgage payments, an ARM may be too risky for your situation.

The length of time is also a very important consideration. Savings on an ARM are guaranteed until the end of the first adjustment period. However, even if interest rates go up you can still save money on an ARM versus a fixed rate mortgage for a few years. Typically, if your mortgage is for less than three or four years, an ARM is the best option. Alternatively, if your mortgage is for more than four years, a fixed rate mortgage is typically the best option.

The last thing to consider is your willingness to take on risk. With an ARM, there is a chance that interest rates could go up. Consequently, your monthly payments could increase substantially. You should assess your own financial condition to see if you can afford to take on higher mortgage payments if interest rates turned sour. If you cannot afford these risks, then a fixed rate mortgage may be your best option.

Click Here to Download Our Mortgage Type Worksheet

One of the most important things to consider before applying for credit cards or taking out a mortgage is your personal debt capacity - that is, the amount of debt that you can comfortably afford. One of the most accurate methods to determine this is to create a monthly budget with cash receipts for income and cash disbursements for expenses. The amount left over when subtracting these two amounts is the cash you have left over to make payments on your debts. If there is no cash left over (or negative cash left over) you should not take on new debt, since you will not be able to pay down the principle while making interest payments without drawing into your assets. This method also allows you to analyze where your money goes. By cutting your spending in some areas, you can increase the amount of money that you have available to finance debt payments.

Another related concept to keep in mind is the 20% rule, which states that your monthly debt payments shouldn't exceed 20% of your total monthly disposable income (not including your mortgage). For example, if you have $1,000 in monthly disposable income, your debt payments shouldn't exceed $200 per month. This rule, however, becomes less important for those with higher monthly incomes.

Click Here to Download Our Debt Capacity Worksheet