After going through the multiple options of which home is right for you, and shopping for mortgage offers, there is still one very important choice you have to make: deciding between a fixed-rate mortgage and an adjustable-rate mortgage (ARM). A fixed-rate mortgage is a type of loan where the interest rate and monthly mortgage payments stay the same throughout the life of the loan. Conversely, like the name implies, an adjustable-rate mortgage has an interest rate that starts out lower, but can fluctuate with the housing index rate.
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What’s a fixed-rate mortgage?
A fixed-rate mortgage is always the more secure and conservative choice of the two. The interest rate is higher than what an adjustable-rate mortgage starts out at, but there is the possibility that it could end up being lower than what an ARM will end up being after the introductory rate has elapsed. Fixed rate repayment terms for a loan are typically 15, 20 or 30 years. Since fixed rate loans are usually sold to a secondary market, there isn’t really any wiggle room as far as customizing the loan.
If I have a fixed-rate mortgage, will my monthly payments be the same throughout the loan?
Not necessarily. Your monthly payment includes a number of costs – the mortgage payment itself, mortgage interest, taxes, and insurance, commonly known as PITI, for payment, interest, taxes and insurance. While the payment + interest portion of your monthly payment will stay the same throughout the life of the loan, your taxes may rise, you may need to pay more or less in homeowner’s insurance, and if you started off paying mortgage insurance, you may not need to pay for the entire term.
What’s an adjustable-rate mortgage?
An adjustable-rate mortgage can be considered a bit of a gamble. Your interest rate stays the same for an introductory period (it’s usually a lower rate than you’d get with a fixed-rate loan), but then fluctuates according to a predetermined index such as the London Interbank Offered Rate (LIBOR), the National Average Contract Mortgage Rate or the prime rate. This means that your monthly mortgage payments will change after the introductory period.
Let’s say you have a 5/1 ARM with a 4/2/7 cap, and the interest rate is determined by the LIBOR plus 2%. That’s a lot of numbers – the interpretation isn’t as straightforward as, say, a 30-year fixed loan. But it tells you most of what you need to know: when and how much your interest rate will change.
An ARM is expressed as:
(introductory period in years) / (adjustment period) ARM with an (initial adjustment) / (subsequent adjustment) / (lifetime adjustment) cap
We can then interpret this loan in the following manner:
- 5 (introductory period): Your interest rate will stay the same for the first 5 years.
- 1 (adjustment period): After 5 years, your interest rate will change every year.
- 4 (initial adjustment cap): The first adjustment, which comes when the 5-year introductory period ends, cannot be more than 4%.
- 2 (subsequent adjustment cap): After the first adjustment, your interest rate cannot rise more than 2% with any single adjustment.
- 7 (lifetime cap): Your interest rate will never increase more than 7% over your initial rate.
- LIBOR + 2%: When your rate is adjusted, it will be calculated by taking the LIBOR and adding 2%.
The upside of an adjustable-rate mortgage is that your initial rate is usually lower, and if the index rate falls, you’ll enjoy lower borrowing costs than someone with a fixed-rate mortgage. The downside is that you might find your rate increasing substantially if the index rate rises over the loan term.
Who should consider an adjustable-rate mortgage?
If you plan to hold the mortgage for a very short time (particularly if you plan to sell during the intro period), you’ll be protected against rate increases.
If you think that interest rates will remain low (they’ve been at rock-bottom for years, and probably will continue to be so through 2015) and can handle a potentially larger payment, you may save money by gambling on lower rates downstream.
Sometimes an ARM can be attractive to first-time homeowners because the loan amounts are usually higher, and they start out being cheaper. However, they can also be more confusing and volatile, which can make them a hardship as well.
Who should stick with a fixed-rate mortgage?
The longer you stay in your house (and thus keep your mortgage) the more uncertainty there is in predicting future interest rates. If you’re going to stick around for 30 years, you’re more vulnerable to substantial rate hikes than someone who’s holding the mortgage for only one year past the intro period.
If you can’t afford your monthly payments if the interest rate goes up sharply, you should avoid the temptation of a lower initial rate.
If you think that rates will rise in the future, it doesn’t make sense to bet otherwise.
|Type of Mortgage||Pros||Cons|
|Fixed-rate Mortgage||The interest rate stays the same over the entire life of the loan.||If interest rates happen to fall, you will end up paying more than you had to.|
|Adjustable-rate mortgage (ARM)||Introductory interest rate is lower than market standard.If the loan is paid off before the interest rate is adjusted, you pay less than you would have otherwise.
Lower interest rate can enable you to save more money for the future in a high interest yield account.
|Interest rate can rise higher than a locked in fixed rate.Terms and conditions can be hard to understand, making it easier for a shady lenders to take advantage of you.
Rate adjustment has the potential to bring your payments outside of your budget.
If you are planning on staying in the same home for a longer period of time, or even the rest of your life, a fixed-rate mortgage is a much safer bet. Especially now, with interest rates for homeowner’s at historic lows, there’s very little reason to pick an ARM over a fixed-rate mortgage. However, you could be looking to buy in an area with high interest rates, if you already have a fixed-rate mortgage and prices go down you may be tempted to refinance your loan to get the lower rate. This can end up being extremely costly since you will have to pay closing fees all over again.
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