Fixed Rate Mortgages
The fixed rate is one of the most popular mortgage programs. With a 30 year fixed rate mortgage, for example, you lock in today’s interest rate for thirty years. The 30 year fixed is also the most popular of the fixed terms which can also include 25 year, 20 year, 15 year, and 10 year terms. The opposite of a fixed rate mortgage is an adjustable rate mortgage (ARM). With interest rates near historic lows, locking in today’s rate is a very smart move for most people.
The primary advantage of a fixed rate mortgage is predictability. Unlike an ARM, your rate will never change for the life of your loan, and, therefore, your payments will never increase. You don’t have to worry about changes in interest rates, the financial index they are based on or how the payments are structured. Depending on the length of the term, the mortgage will have the additional benefit of significantly lower payments than those of shorter term fixed rate products. For example, a 30 year fixed rate mortgage could save you hundreds of dollars a month compared to a 20year or 15year fixed. However, keep in mind that since the term of the loan is longer, you’ll pay more total interest over the life of the loan than you would on a mortgage with a shorter term.
Adjustable Rate Mortgages
An adjustable rate mortgage (ARM) has an interest rate that varies over time. At the beginning of an ARM, for a specified period of time, the interest rate remains fixed and is usually very low. After this initial period is over, the interest rate will change periodically (usually every 12 months, depending on your loan product) for the remainder of the loan term. The rate may go up or down according to a nationally published index, such as United States Treasury Bills (T-bills), the 11th District Cost of Funds Index (COFI), or the London Interbank Offering Rate Index (LIBOR). It is important to keep in mind that most ARMs contain rate caps, which limit the amount your rate can rise overall and how much it can rise per adjustment period. For example, as its name suggests, a 5-year ARM has a fixed interest rate for the first 5 years, and will change annually after that.
ARMs can be advantageous because they offer interest rates that are extremely attractive. Borrowers who are looking for a low initial monthly payment and are comfortable with a rate that can go up or down will often find an ARM appealing. ARMs also offer several other benefits including the opportunity to qualify for a larger loan and the ability to save money in the short-term. If you expect your income to rise or plan to sell your home within a short time period, an ARM may be a good choice for you. However, homebuyers considering this type of mortgage should be prepared financially for a possible increase in rate and/or payments. If you are considering an adjustable rate mortgage it is crucial that you work with an experienced, reputable mortgage expert. What you will pay for your ARM now and into the future depends not just on the initial interest rate but on other variables including the index, margin, adjustment frequency, interest rate cap, convertibility and so on.
Which option is right for you?
- Do you want a low rate? One of the greatest advantages of an ARM is that it can significantly reduce the cost of your mortgage. In most cases it offers a lower interest rate, and therefore lower initial monthly payments, compared to its fixed rate counterpart.
- Do you plan to move or refinance in the next 5 to 7 years? If you plan on selling your home in a few years, or you are interested in a short-term mortgage option, a 5-year ARM or 7-year ARM can significantly lower the interest rate on your loan, saving you money every month. Borrowers who are planning to move before the end of the initial fixed period often use an ARM because the payment is lower than a typical 30-year fixed mortgage. However, if you are considering an ARM because you plan to sell your home you should also consider the possibility of real estate market fluctuations and how such swings in value may affect your ability to sell.
- Are you comfortable with a monthly mortgage payment that can go up or down? If you are not bothered by a mortgage payment that can adjust periodically, are confident that you know how long you will be in your home, and you like the idea of increased cash flow due to a lower mortgage interest rate, an adjustable rate mortgage might make sense for you.
- Are you looking to lower your mortgage payments? If so, a long-term fixed rate mortgage can offer you low monthly payments. That can make home ownership more affordable on a month-to-month basis. And remember, if you choose a 30 year mortgage, there’s nothing to stop you from paying down the loan quicker than 30 years by making a higher payment whenever you want.
- Does the stability of a fixed payment give you peace of mind? If you’re the type of person who might stay up late at nights worrying about the uncertainty of an adjustable rate mortgage, a fixed may be the right choice for you. Many people are more comfortable with a fixed rate mortgage, because they know what tomorrow’s payment will be.