So you’ve found your ideal house, you’ve safely tucked your down payment money somewhere, and the bank rep assured you that you will get pre-approved.
You’re about ready to sign the financing agreement soon – but have you given serious thought to what kind of mortgage you should get?
Fixed-rate mortgages and adjustable-rate mortgages have their own pros and cons. In this article, we will look at how the latter type can fit your mortgage requirements.
To differentiate the two, a fixed-rate mortgage’s interest rate stays constant throughout the term of the loan while an adjustable-rate’s (ARM) interest rate might shift over time.
Normally, the rate fluctuation will move this way: the ARMs start off at a lower rate compared to their fixed-rate counterparts but only until the introductory period remains in effect.
Then, anytime between one month and five years (or beyond), the introductory period ends and the rate goes up in all likelihood. This, of course, causes the monthly payment to increase accordingly.
How do the lenders determine how much the interest rates will change? Well, they basically benchmark the rate to a reliable financial index such as the London Interbank Offered Rate (LIBOR).
When the index goes up, the interest rates will follow suit. When the index goes down, the interest rate will most likely go down as well.
Some borrowers can experience a payment shock when the rates abruptly climb – unless there’s a cap that limits the amount of interest rate increase over the life of the loan.
In addition to the use of fixed vs ARM calculator, it’s is good to know the pros and cons of an adjustable-rate mortgage so you can decide whether this is the kind of loan for you.
After being armed with the necessary knowledge, you can shop for lenders and then begin the exciting process of purchasing your home.
The Advantages of an ARM
Many home buyers pick this type of loan for these popular reasons:
Lower Opening Interest Rate
It is a known fact that the initial interest rate for an adjustable rate mortgage (ARM) is lower than what you would get if you have taken a 30-year fixed-rate mortgage.
Lenders will normally peg the rate for the first three, five, seven, or ten years of the loan and then modify it semi-annually or annually for the rest of the 30-year term.
At first glance, buyers can see that the low rate can make it easier and more affordable to buy a home through an ARM compared to other mortgage programs.
If you foresee that there will be a major change in your life in the coming years, like perhaps relocating to another city or state because of work or family, then an ARM could be more beneficial.
During the time that you will stay in the house, you might as well maximize the ARM’s low fixed-rate introductory offer.
Then, you can sell the house before the period expires so you do not have to worry about the fluctuating interest rates afterward.
Lower Initially Monthly Payment
Because the initial interest rate of an ARM is lower, this means that your initial monthly mortgage payment will also be lower.
Any reduction on your monthly mortgage payment means extra money that can go to other needs.
This can give you better financial flexibility as a homeowner.
Even if the monthly mortgage payment for an ARM can go up (or down) over the life of a loan, you cannot discount the benefit of a lower monthly payment.
It can provide more financial breathing room during times when you really need the money.
Better Protection By Rate and Payment Caps
The cool thing about ARMs is that you can avail of several types of caps to protect yourself against ‘payment shock’.
These caps set the limit on the increases in your mortgage rate and the size of your payment.
It could be an interest-rate cap which sets how much the rate can change each time it moves and on the total rate change over the term of the loan.
Or, it could be a cap on how much the payment can grow every time the rate fluctuates. Your lender can (and should) explain the risks attached to each cap and do simulation or use ARMs calculator so you can see how your monthly payments will play out.
Benefit When Rates (do) Go Down
Perhaps this is the only loan package that puts you at an advantage when the interest rates fall because your mortgage rate goes down with it.
When the adjustable rate period of your ARM is in effect, your lender will adjust your mortgage rate annually or semi-annually. During this time, your mortgage rate will be a fully-indexed rate and will behave according to an index.
The index will have to be a reliable basis such as LIBOR or the treasury rate that moves due to many economic factors. As we have previously said, when the index goes up, your mortgage rate will also go up.
However, if the index goes down, so does your mortgage rate and eventually, your monthly payment – which will prospectively save you some money.
Although no one can accurately predict how the interest rates will adjust several years ahead, one thing is certain: an ARM benefits you with a lower mortgage rate if and when interest rates fall.
The Disadvantages of an ARM
Here are the main disadvantages to consider:
Drastic Change in Interest Rates
If you were to look at the historical behavior of interest rates, you would notice that they tend to increase more frequently than they decrease.
Any increase in the interest rate would affect your ARM negatively to your disadvantage.
A sudden surge in your interest rate after the fixed-rate portion of the loan has lapsed would make your monthly payment go up substantially.
This could disrupt your normal household budget and may cause you to find it punishing to pay your mortgage.
Could Mess up Your Budget
Since you won’t have any idea what your new interest rate would be, making long-term financial plans could prove challenging. Even if you try to rely on expert opinions about future financial projections, there’s really no way to accurately predict how much the rate will rise or fall.
Your best bet is to have an estimate that’s hopefully close enough but you will still find it difficult to project how much you will be spending each month for your mortgage payment.
You might plan carefully but there is still the possibility that you might not be able to sell or refinance your loan in the future. If you default on your loan after the fixed-rate period is over, you might even lose your home.
You Pay A Penalty If You Pay Off Your Loan Early
Believe it or not, some lenders actually penalize the borrower for paying off their loans ahead of schedule and some ARMs also carry this prepayment penalty.
Whether you sell, refinance or pay off your loan, lenders can charge you with this fee.
So if you foresee that you will sell or refinance or pay off your loan within the first five years of the mortgage, you’d better negotiate with your lender to waive this provision.
Housing Market Exposure
Picture this for a moment: you’ve been paying for your home religiously for the past five years and then property prices plummet at a time when you’re ready to refinance.
In such a scenario, refinancing your home into a fixed-rate mortgage would be very difficult and could put you at a disadvantage.
Adjustable Vs Fixed Rate Mortgage
You should try to consider all of these things before you decide whether to get a fixed-rate mortgage or an adjustable-rate mortgage. But, that’s not all – you should also look at these important questions when deciding which type is the best for you:
1. How Long Will You Stay In The Home?
If you plan to occupy the home only for a few years, then an ARM would be a perfect choice because you can negotiate for a reasonably-priced 3/1 or 5/1 ARM.
A 3/1 loan means you pay a low fixed-rate for the first 3 years and then it turns to a 1-year adjustable-rate for the next 27 years. The 5/1 carries the low fixed-rate for the first five years before shifting to an adjustable rate loan for the remaining 25 years.
For the first few years, your payment will be lower so you can start building up your savings for a bigger home in the future.
Another benefit is that you will not be susceptible to huge rate adjustments since you will vacate the house before the adjustable-rate period starts.
2. How Frequently Do Lenders Adjust The ARM Rate And When Do They Make It?
After you’re done with the initial fixed-rate period, lenders will normally adjust the ARM rate every year on the anniversary date of the mortgage.
However, they determine and set the new rate around 45 days before the actual anniversary according to the benchmarked index.
You might find that there are ARMs that adjust as often as every month. If that frequency is beyond your level of comfort, a fixed-rate mortgage might better suit your purpose.
3. How Is The Interest Rate Going To Behave In The Near Future?
During times of soaring interest rates, ARMs become preferable because as a borrower, you want the lower initial rates to work in your favor and take you closer to your dream house.
When rates are falling, you can still have great odds of getting lower payments even if you don’t refinance. However, when interest rates are generally low, fixed-rate mortgages will give you the edge.
4. Should The Interest Rates Rocket, Would You Still Be Able To Make Your Monthly Payment?
If you take out a $150,000 one-year adjustable-rate mortgage with 2/6 caps and start with a 5.75% ARM, you could end up with an 11.75% interest later.
That being the case, would you still be able to afford the monthly payment?
When Should You Choose an ARM?
Between an ARM and a fixed-rate mortgage, you’d want to choose the former if it isn’t in your plans to live in your house for a long, long time. It just doesn’t seem like a good idea to take a 30-year fixed-rate mortgage on a house when you plan to move after five or seven years.
You could also go for an ARM when you want to borrow more than your area’s loan limit. Fixed-rate pricing just doesn’t go well for jumbo loans because the premium between a fixed-rate loan within the limits and outside the limits can balloon up to 1.5 percent.
On the other hand, jumbo ARM interest rates often blast fixed-rate mortgage rates that can go as wide as 2.5% or even more.
If you’re the type of person who wants to know exactly how much you need to pay every month on your mortgage, you’re a fixed-rate loan guy.
You won’t have to stress yourself every time the interest rates go up because you’re safely locked in. Fixed-rate mortgages suit households that intend to stay in their newly-acquired home beyond ten years.