If you are looking to purchase a home, one of the most important decisions you will make when you apply for a mortgage is whether to get an adjustable-rate mortgage (ARM) or fixed-rate mortgage. With an ARM, your interest rate can change over time and this may affect your monthly payments. This blog post discusses the pros and cons of both types of mortgages in-depth so that you can make an educated decision on what type is best for your situation.
Understanding how these loans differ
No matter what kind of loan you are thinking about getting, it’s important to understand the difference between a fixed-rate mortgage and an adjustable-rate mortgage. A fixed-rate mortgage is one where your monthly payments will remain the same for the entire term of the loan. An adjustable rate mortgage, however, has rates that change periodically during the life of the loan.
You will initially pay a lower interest rate on an adjustable-rate mortgage than you would on a fixed-rate one. However, there is no guarantee that your monthly payments won’t go up in the future if your lender decides to raise rates. People often choose fixed-rate mortgages when their income is uncertain or when they want to know their exact monthly payments in advance. The key difference between the two types of loans is that your payments could be significantly different each month with an adjustable-rate mortgage.
Comparing interest rates
With a fixed-rate mortgage, your monthly payments stay the same for the entire period of the loan. You can also pre-pay or make extra principal payments during this period to reduce the total interest you will pay over time. On an adjustable rate mortgage (ARM), any change in interest rates will be incorporated into your monthly payments. For example, if you get a fixed-rate mortgage for 30 years at 4 percent and the rates on adjustable rate mortgages rise to 6 percent, your monthly payments will stay the same. But if you get an adjustable rate mortgage, the interest rate may rise from 4 percent to 6 percent. In that case, even though you’d still owe the same amount of money at the end of 30 years, your monthly payments would go up.
Advantages of an adjustable-rate mortgage
Even with the potential for rate fluctuations, there are a lot of advantages to getting an ARM, especially if you believe that interest rates will drop a great deal in the near future or stay low for years. An adjustable-rate mortgage allows borrowers to get loans with lower rates than they could get with fixed-rate mortgages. Also, less money is tied up in housing.
An adjustable-rate mortgage may also be the best option for you if you plan to stay in your home for only a short time, because it saves money on interest charges compared to a fixed-rate mortgage. But this type of loan does carry more risk than having a fixed rate for 30 or 15 years.
Additionally, you should know that an adjustable-rate mortgage could be less expensive than a comparable fixed rate mortgage for the first few years. However, as time goes on and interest rates rise (and they often do), your adjustable rate mortgage will become more expensive.
Even so, an adjustable-rate loan may make sense if you don’t plan to stay in your house very long. But people with adjustable-rate loans who want to stay in their homes for a long time would be better off taking out a fixed-rate loan and paying the higher monthly payments—especially if interest rates keep rising.
Advantages of fixed-rate mortgages
A fixed-rate mortgage is a safer way to go because you know exactly what your payments will be for the entire life of the loan. With a fixed-rate mortgage, most lenders allow you to partially prepay your loan whenever you want without a penalty.
Considerations
If the rates on adjustable-rate mortgages go down, your monthly payments probably will go down as well if you have an ARM. On the other hand, if interest rates increase, your monthly payment could go up considerably unless your lender allows you to make a “cost-of-living” adjustment in your loan amount.
Keep in mind, however, adjustable-rate mortgages come with a cap on the maximum interest rate the loan can reach. This way, you won’t have to worry about any future increases in interest rates. For example, if a lender sets a maximum rate of 7 percent, your monthly payments will never go higher than that amount, regardless of market changes.
Usually, you can refinance from an ARM to a fixed-rate mortgage fairly easily when interest rates drop, but refinancing from a fixed-rate to an adjustable rate loan may be impossible in the future. Finally, if you get an ARM and interest rates rise substantially, you might end up owing more money than your house is worth. If that happens, you could lose your home unless you can sell it or refinance into a new loan.
Take time to make your decision
Ultimately, when deciding which type of mortgage to get, think about where current interest rates are and where you think they’re headed. Ask yourself whether you can pay more on your monthly payments to get a fixed-rate mortgage or if you might want to be able to make smaller payments with an ARM. Also, consider how long it will take before you expect to sell your house or plan to stay in it. You’ll probably benefit most from an ARM if you plan to stay no more than five years or so. It’s important that no matter what, you weigh both the pros and cons of each mortgage carefully before making your final decision.
