Whether you're getting your first home loan or are re-entering the housing market after a long time, choosing a mortgage product is definitely a tricky affair. There are many factors to consider aside from your financial situation, such as the current interest rates, how long you plan to live in the house, and so on.
One valuable thing you need to know are the key differences between a fixed-rate mortgage and an adjustable-rate mortgage. Here we've laid them out for you so you can evaluate each of the pros and cons before making that big decision.
Fixed-Rate Mortgage
A fixed-rate mortgage is a popular choice for many home buyers since the payment is fixed for the entire term of the loan. The most common terms are the 30-year and the 15-year fixed mortgages.
For the 30-year fixed mortgage, the monthly payments can be relatively low because of the long amortization period. It's a great choice for many borrowers who want to free up some of their money to achieve other goals and build a safe cushion of emergency funds.
On the other hand, while the 15-year fixed is also popular, monthly payments are higher since the entire loan must be paid off in half the amount of time. It’s best for those who have enough room in their budget and don’t want to be stuck in a substantial period of 30 years.
So if you are ready to settle down in an area or neighborhood, you’re content with your career and want a house that will accommodate your growing family, a 30- or a 15-year mortgage with their locked-in rate can be your best choice.
Pros and Cons
1. Your interest rates and payments remain the same.
Your rates and mortgage payments remain the same throughout the life of your loan so you are protected against the market's fluctuating interest rates. Even if the mortgage market turns for the worse, there’s no need to worry about paying more in interest. This offers the stability and certainty that many homeowners want since they can easily control their budget.
2. The terms are simpler to understand.
This is an advantage for first-time home buyers who may feel overwhelmed with the different loan terms and options. Fixed-rate mortgages are also virtually identical from lender to lender.
3. You can refinance if you want to take advantage of lower interest rates.
Since fixed-rate mortgage holders will be stuck with the same interest rates and payments, the only way to take advantage of lower rates later on is to refinance.
4. Your upfront costs may be more expensive.
Despite the security and stability that fixed-rate mortgages offer, they can be more expensive. The typical closing costs and monthly payments are often higher compared to an adjustable rate mortgage. Because of this, borrowers with poor credit may have difficulty getting a good deal using this mortgage term.
Situations where a fixed-rate mortgage might be best for you
You look forward to purchasing your forever home.
It's great for buyers who already want to settle down and stay in their home for the most of their lives or for people who plan to age in place. Instead of choosing an adjustable rate mortgage where they may end up paying more on interest due to varying rates, a 30-year or 15-year home loan with regular monthly payments is a great financial tool. It may help you assess your financial capability, plan your budget, and reduce the risk of paying more in interest over the life of your loan.
You want stability.
You don’t have to deal with anything unexpected when paying your mortgage payments, making budgeting easier. It decreases the uncertainty you can otherwise get if you use an ARM. Your housing payments don’t change so you can manage your finances better, especially since you also need to deal with other costs of homeownership.
Adjustable-Rate Mortgage
Adjustable-rate mortgages or ARMs are usually named in two numbers, such as the 10/1 ARM or the 5/1 ARM. The first number (“10”) indicates the period the loan's interest rate is fixed, while the second number (“1”) specifies the annual frequency the interest adjusts after the initial fixed period. For that example, the introductory rate lasts 10 years and after that, the rate can change once a year after one year.
The introductory rate may last for five years (5/1 ARM), seven years (7/1 ARM), and 10 years (10/1 ARM). These conditions may depend on what the lender offers and the specific terms of your loan.
The ARM rate adjusts annually based on the benchmark interest rate chosen by the lender. The most common benchmarks include the one-year London Interbank Offer Rate (LIBOR) and the weekly yield on the one-year Treasury bill. Other ARMs also have specific caps on how high or low the interest rate can go.
Pros and Cons
1. You'll have lower initial monthly payments.
In the initial fixed rate period of your ARM, you will pay less in principal and interest than you would with a traditional loan. Whether it’s the first 5, 7, or 10-year period, it can help you save money that you can use to purchase items for your new home or allocate on other high-yielding investments. In some loan terms, you can also pay off your loan early without having to deal with prepayment penalties.
2. It’s a riskier mortgage.
You need to know what you are getting into when you choose an ARM. It can be a gamble because while the initial interest rate is fixed for a specific amount of time, it’s highly possible to have a higher interest rate in the future. This uncertainty makes it riskier than a fixed-rate mortgage. However, the potential increase in your interest rate will still depend on the terms of your loan.
Home buyers should evaluate whether they can handle these associated risks and if there is enough wiggle room in their budget just in case rate rises in the future.
3. Your loan terms can be difficult to understand.
Unlike the terms in a fixed-rate mortgage, ARMs can be difficult to understand. Lenders typically have more flexibility when determining specific requirements, such as margins, adjustment indexes, caps on the annual adjustment, and other factors. It can also be customized depending on the needs of the borrower. These things might sound confusing or overwhelming to many borrowers, especially first-time home buyers.
Situations where an ARM might be best for you
You're planning to relocate soon.
ARMs might make more sense and more appealing to younger, first-time home buyers who want to purchase a starter home. They are the ones who usually have plans to move to a new place after 5 to 7 years or don’t want to settle in one place for long, such as those who will need to relocate due to employment.
You want to get a larger loan to purchase a nicer house.
Lenders can use the lower rates and payments early in the loan’s term when qualifying borrowers. Through this, borrowers can buy larger homes than they could afford with a traditional fixed mortgage. If you’re this kind of buyer, the ARM might be the way to go. This strategy was popular among many borrowers during the housing boom.
You’re anticipating a lifestyle change.
If you’re expecting a significant salary increase or will be advancing in your career soon, an ARM may give you the most advantage. With the lower monthly payments, you can save money now while you have limited income. And then when your income increases just in time, you will then be comfortable with the prospect of making higher payments when your ARM adjusts.
An ARM is also a good choice if you want to keep your long-term options open and not be restricted with a fixed rate mortgage, where the payments will neither go up nor down.
Fixed rate vs ARM: Which one wins?
While ARMs have some appeal, especially to younger, first-time home buyers who want lower initial payments and flexibility, make sure that your income can handle the higher monthly payments once the rates increase. Otherwise, a fixed-rate mortgage remains the ideal option if you don't want to push beyond the boundaries of your budget to own your dream home. For both loan options, you and your lender will need to carefully assess your financial situation, your long-term plans, and whether choosing one over the other will make more sense to you in the long run.
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