Comparing Fixed-Rate vs. Adjustable-Rate Mortgages
There's a lot to think about before obtaining a mortgage. First of all, how much home can you afford? And do you feel comfortable spending your entire home-buying budget?
What often gets overlooked, though, is the mortgage type. That's why we decided to dedicate an entire article to fixed-rate vs. adjustable-rate mortgages. There are similarities and differences between both — and the one you choose can significantly impact your financial future.
What is an adjustable-rate mortgage?
An adjustable-rate mortgage, or ARM, caters to borrowers interested in making the smallest payment possible during their first few years in a home. As the name suggests, an ARM's rate changes over time. Homeowners who opt for this home loan will see their payments increase or decrease depending on market interest rates.
Let's consider an example. Say you researched types of ARM loans and chose to go with a 5/1 ARM. The introductory fixed rate lasts for five years, while the remaining 25 years will fluctuate based on indexes and margins.
The good news is that these loans come with caps limiting how much and how often your rate and payment can change. We encourage you to learn more about the basics of ARMs by talking to an experienced mortgage consultant.
ARM pros and cons
An adjustable-rate mortgage can serve as a valuable financial tool. That said, it's essential to understand the advantages and disadvantages of an ARM before moving forward with this plan.
Low initial payments - Mortgage rates figure to remain low for the foreseeable future. And since lenders usually set ARM interest rates lower than fixed-rate loans, you could have a much lower monthly payment with this mortgage type. Just remember that your rate and payment will change over time.
Flexibility - Every loan situation is different. Maybe you'd like to buy a starter home to start building equity but hope to be in your forever home within five years. An ARM gives you the flexibility to save up for a bigger house and sell your current home before the fixed-rate period ends.
The possibility of even lower payments - There's a chance that your payments could decrease down the road. Again, it all hinges on market interest rates at the time of your initial rate adjustment.
Higher interest rates and payments - This is the most obvious downside of an adjustable-rate mortgage. At the beginning of the article, the caps we mentioned sometimes aren't enough to keep your introductory rate from rising to a level you hadn't anticipated. You never want to think about foreclosure, but it will undoubtedly creep into your mind if your income ever decreases as your rate and payments increase.
Loan complexity - Lenders create adjustable-rate mortgages different from fixed-rate mortgages. Not only are there varying structures and fees with an ARM, but there could also be a prepayment penalty. Unfortunately, a prepayment penalty makes selling or refinancing your home more challenging and expensive.
Uncertainty - Every homeowner likes the idea of an incredibly low mortgage payment. But do you want to get accustomed to a lifestyle only to see it drastically change due to an increase in your mortgage rate and payment? Selecting an ARM rate is rolling the dice in several ways.
What is a fixed-rate mortgage?
A fixed-rate mortgage is a home loan in which the interest rate stays the same over the life of the loan. There's no introductory period with this type of home loan, so there's no need to worry about future market conditions. Most borrowers prefer the fixed-rate mortgage because of its stability and "set it and forget it" terms.
Expect to pay a great deal of attention to your amortization schedule. Though your payment will not change, the amount that goes toward principal and interest will differ each month. It's common for a borrower with a fixed-rate mortgage to pay more interest at the beginning of their term and more principal at the end.
Numerous fixed-rate mortgages are available for homeowners, including conventional, FHA, and VA loans. You can also choose between a 30-year or 15-year loan. Ask your lender about program requirements and which term length makes sense for your situation.
Fixed-rate mortgage pros and cons
Not every borrower will benefit from a fixed-rate mortgage. Then again, this type of home loan is a no-brainer for others. Be sure to weigh the pros and cons in advance.
Flexibility - Similar to adjustable-rate mortgages, a fixed-rate loan allows you to do other things with your money as you make payments. That could mean wiping out high-interest debt, building up a savings account, or contributing to your child's college fund. And with no fluctuation in payments, there are never any surprises.
Tax advantages - It's easy to get discouraged in the early years of your amortization schedule. After all, who enjoys seeing their hard-earned money going primarily toward interest? At least you can deduct that mortgage interest from your taxes in the spring.
Predictable - Whether you choose a 15- or 30-year mortgage, you're probably going to spend a sizable chunk of your working years paying it off. Your budget might change throughout the years, but your monthly payment won't be with a fixed-rate home loan. That predictability can't be overstated in an ever-changing world.
Higher interest rates - Yes, the rate on a fixed-rate mortgage is typically higher than an ARM rate. But it would be best if you never decided on a home loan by the rate alone. You can take steps to improve your interest rate, such as lowering your debt-to-income ratio (DTI) and raising your credit score.
Tough to qualify (at times) - Higher mortgage rates translate to less affordable payments. As such, lenders turn away more applicants in an unfavorable borrowing environment.
Which loan program is right for you?
No two financial situations are the same. While some folks prefer a fixed-rate mortgage, others might choose an adjustable-rate loan. Consider the following situations as you discuss with your lender.
You won't be in your home for long
Savvy borrowers often lean toward an ARM because the introductory rate tends to be lower than an interest rate with a fixed-rate loan. These folks might only be in their home for a few years but benefit from building more equity in a shorter period. You can enjoy significant savings with an ARM as long as you know when the rate resets.
You expect to have a higher income
Maybe you're just starting your career and not earning a high salary quite yet. However, you're confident you'll see a boost in your income in a few years. An adjustable-rate mortgage keeps payments low until you have a little more breathing room in your budget.
You're nearing retirement
As you prepare for retirement, do you see yourself downsizing in the next few years? Then give yourself a chance to add to your nest egg with an adjustable-rate mortgage. Just be sure to time your move accordingly so you never have to worry about a higher payment.
You're buying your forever home
Perhaps you've found the one and expect to make it yours for the long run. A lot can happen between the day you close and the day you pay off your home, which is why it's probably best to choose the most budget-friendly option. Remember that the rate on a fixed-year mortgage never changes and that you can make extra payments toward the principal balance as necessary.
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You know that money will be tight for a while
Think about what the next 5-10 years could hold. If a family is in your future, you're going to want predictability in many areas, especially your mortgage. A fixed-rate mortgage makes a lot of sense in this case because you'll never have to concern yourself with the market.