Chances are when you think about a mortgage, the first thing that comes to mind is the fixed rate mortgage. It is the most common type of mortgage, but it’s not the only one available today. You can also choose the adjustable rate mortgage. Many people assume the ARM is too risky because of its adjusting rate, but is the fixed rate right for you?
Understanding the Difference
First, let’s look at the difference between the fixed rate and adjustable rate.
The fixed rate loan, as the name suggests, has a rate that remains the same for the life of the loan. You never have to worry about the interest rate increasing in the future. You can lock in your interest rate for a 15, 20, 25, or 30-year term. Fixed rate mortgages are nice because you never have to guess what your mortgage payment will be.
The ARM loan doesn’t have a fixed rate. Instead, it can adjust after the initial introductory period. The introductory period depends on the chosen ARM. For example, a 3/1 ARM has a 3-year fixed rate and then it can adjust annually afterward. A 5/1 ARM would have a fixed rate for 5 years and then adjust annually.
The rate adjusts according to the chosen index and predetermined margin. For example, if your index is the prime rate and your margin is 2%, your adjusted rate on your adjustment date would be 2% plus the prime rate at that time.
What’s Good About the Fixed Rate?
The fixed rate loan has its obvious benefits. You never have to worry about a changing interest rate. You also don’t have to worry about budgeting your new payment. The only thing that could change about your payment with a fixed rate loan is the amount you pay monthly for taxes and insurance. That’s the case with any type of loan that you take though, your mortgage company doesn’t have control over your taxes or insurance.
The fixed rate loan can be a good choice if interest rates are low when you apply for a mortgage. If you want to lock that rate in for the life of the loan, you need the fixed rate loan. This way you always have the low rate. You don’t have to worry about it changing or needing to refinance in order to get the lower rate.
The fixed rate loan is good for those that know they will stay in their home for the long-term. You don’t have any way to predict what will happen to interest rates moving forward and with the fixed rate, you don’t have to care.
What’s Good About the ARM?
The adjustable rate mortgage (ARM), often provides you with a lower interest rate to start. It’s even lower than most fixed rates. In exchange for that low rate for the introductory period, you then have an adjustable rate for the remainder of the term. So while the low introductory rate is good, the risk of the adjusting rate can be scary.
The lower rate can help many homeowners qualify for a larger loan. The lower interest rate keeps your payment down, which in turn helps keep your debt ratio lower. If you are on the border of the maximum debt ratio for the chosen loan program, this can be a saving grace.
Homebuyers that typically benefit from the ARM the most are those that plan to live in the home for the short-term. If you know you will move before the adjustment period begins, you get the low-interest rate for the entire time you are in the home. If plans change, you can always refinance the loan before it adjusts so that you don’t have to deal with that part of the term.
Which Should You Choose?
So which loan program should you choose? It depends on your situation. Ask yourself the following questions:
– How long will you be in the home? If it’s short-term, consider the ARM, if it’s long-term or you don’t know, consider the fixed-rate loan.
– Do you need the extra room in the payment to qualify with your debt ratio? If you are on the cusp, the ARM may be the better option.
– Do you have income that will increase in the future allowing for the potential higher ARM payment? If you aren’t in a career that will give you a major increase in income (doctor, lawyer, accountant), you may want to stick with the predictable fixed rate loan.
– What are interest rates like? Always consider the interest rates at the time. If they are exceptionally low, you may want to lock in the fixed-rate and put an end to worrying about your future payments.
Choosing the fixed-rate loan or ARM is a personal decision. Choose the loan that seems right for you not only now, but also in the future.