Real Estate Basics: Fixed vs Adjustable Rate Mortgages (ARM)
For most people, the purchase of their home is the biggest financial commitment they will ever make. Not only in the amount of money they will be borrowing, but the time they will spend paying it back—usually 30 years. While buying a home is exciting, it is certainly a nerve-wracking prospect. When shopping for a mortgage, one of the many things to consider is whether you want a fixed mortgage or an ARM. There is no one best answer, and will depend on many factors. Here is a basic overview about these two mortgage products.
What is a Fixed Rate Mortgage?
A fixed rate mortgage is just that—one whose interest rate is fixed the entire life of the loan. No matter what happens with interest rates, you will have the same monthly payment forever, save for refinancing. And then your refinanced mortgage payment amount will remain the same for as long as you are paying the loan. A large majority of people opt for fixed-rate mortgages because of the predictability of the payments. These loans are more straightforward and easy to understand, which also makes them more attractive to home buyers.
What are ARMs?
ARMs do not have set interest rates. Rather, the rates are determined by the performance of a particular economic index. This means that your mortgage payments will fluctuate, either increasing or decreasing at certain points in the life of your loan. Initial interest rates are usually much lower than a traditional loan, which can be attractive to buyers with limited funds. These lower rates may also help you qualify for a bigger loan amount.
These loans are much less common, even though historically, people with ARM loans have paid less in interest compared to those with a fixed rate. But, given that most people are thinking more of their month-to-month financial obligations rather than their total cost over the life of the mortgage, the prospect of unpredictable mortgage payments may be a hard pill to swallow.
But, there are caps in place for ARM loans, meaning that your interest rates can only increase so much over time. There is the yearly cap, which limits how much your interest rate can change from one year to the next. Then there is the lifetime cap, which is the maximum interest rate you can be charged for your mortgage ever. That lifetime cap may seem high, but it is unlikely interest rates would ever reach that point during your loan. There are a variety of indexes the mortgage industry uses to determine rates; talk to lenders to get more information on how they have performed over the years to determine which loan product is best for you.
Which to Pick?
The best product will depend on many individual factors, from your tolerance for risk to projected income over the years. If you do not think you could handle the periods of higher payments that come with an increase in interest rates, or you just do not like the idea of a non-fixed payment, a traditional loan may be the better bet. Even though over the years, ARM mortgages have resulted in lowered interest payments, many financial experts believe fixed rate mortgages are likely the safest bet in this climate. Ultimately, you need to talk with a lender well-versed in these matters who can give you advice based on your circumstances. If you think you will be moving before the ARM is set to adjust, it may be smart to take advantage of the low initial interest rates, without having to worry if payments will increase.
By Kelli Cooper