Which is the better mortgage option for you: fixed or adjustable?
The low initial cost of adjustable-rate mortgages (ARMs) can be very tempting
to home buyers, yet they carry a great deal of uncertainty. Fixed-rate
mortgages (FRM) offer rate and payment security, but they can be more
Here are some pros and cons of ARMs and FRMs.
· Lower rates and payments
early on in the loan term: Because lenders can use the lower payment when
qualifying borrowers, borrowers can purchase larger homes than they otherwise
· Borrowers take advantage of
falling rates without refinancing: Instead of having to pay a whole new set of
closing costs and fees, ARM borrowers just sit back and watch their rates drop.
· Borrowers save and invest
more money: Someone who has a payment that’s $100 less with an ARM than with a
FRM for a couple of years can save that money and earn more from it in a
· A cheap alternative for
borrowers who don’t plan on living in one place for very long to buy a house.
· Rates and payments can raise
significantly over the life of the loan: A 6 percent ARM can end up at 11
percent in just three years if rates rise.
· A borrower’s initial low rate
will adjust to a level higher than the going fixed-rate level in almost every
case, even if rates in the economy as a whole don’t change. This is due to the
fact that ARMs have initial fixed rates that are set artificially low.
· The first adjustment can be a
doozy because some annual caps don’t apply to the initial change. Someone with
an annual cap of 2 percent and a lifetime cap of 6 percent could theoretically
see the rate shoot from 6 percent to 12 percent 12 months after closing if
rates in the overall economy skyrocket.
· ARMs are difficult to
understand. Lenders have much more flexibility when determining margins, caps,
adjustment indexes, etc, so unsophisticated borrowers can easily get confused
or trapped by shady mortgage companies.
· On certain ARMs, called negative
amortization loans, borrowers can end up owing more money than they did at
closing because payments on these loans are set so low (to make the loans even
more affordable), that they only cover part of the interest due. Any additional
amount due gets rolled into the principal balance.
· Rates and payments remain
constant: There won’t be any surprises even if inflation surges out of control
and mortgage rates reach toward 20 percent.
· Stability makes budgeting
easier: People can manage their money with more certainty because their housing
outlays don’t change.
· Simple to understand for
first-time buyers who is typically not well-versed with a 7/1 ARM with 2/6
· To take advantage of falling
rates, FRM holders have to refinance. That means a few thousand dollars in
closing costs, another trip to the title company’s office, and time spent
digging up tax forms, bank statements, etc.
· Can be too expensive for some
borrowers, especially in high-rate environments, because there is no early-on
payment and rate break
· Virtually identical from
lender to lender: While lenders keep many ARMs on their books, most financial
institutions sell their FRMs into the secondary market. As a result, ARMs can
be customized for individual borrowers, while most FRMs can’t.
When considering fixed-rate versus adjustable mortgages, ask yourself the
1. How long do you plan on staying in the home?
If you’re only going to be living in the house a few years, it would make sense
to take the lower-rate ARM, especially if you can get a reasonably priced 3/1
or 5/1 ARM. Your payment and rate will be low and you can build up more savings
for a bigger home down the road. Plus, you’ll never be exposed to huge rate
adjustments because you’ll be moving out before the adjustable rate period
2. How frequently does the ARM adjust, and when
is the adjustment made?
After the initial fixed period, most ARMs adjust every year on the anniversary
of the mortgage. The new rate is actually set about 45 days before the
anniversary, based on the specified index. However, some adjust as frequently
as every month. If that’s too much volatility for you, go with a FRM.
3. What’s the interest rate environment like?
When rates are relatively high, ARMs make sense because their lower initial
rates allow borrowers to reap the benefits of homeownership. The chances are
fairly good that rates will fall down the road too, meaning borrowers will have
a decent chance of getting lower payments even if they don’t refinance.
However, when rates are relatively low, FRMs make more sense. After all, 7
percent is a great rate to borrow money at for 30 years!
4. Could you still afford your monthly payment if
interest rates rise significantly?
On a $150,000, 1-year adjustable-rate mortgage with 2/6 caps, your 5.75 percent
ARM could end up at 11.75 percent. Experts say when fixed mortgage rates are
low, they tend to be a better deal than an ARM, even if you only plan to stay
in the house for a few years.
If you have any questions, please don’t hesitate to call! I’m happy to be of