Fixed or Adjustable? Choosing the Right Mortgage Loan
Part of the home buying process is choosing a mortgage. Most of us can't afford to pay cash for a home, so borrowing to complete the purchase is necessary.
However, when you use a mortgage to buy your home, you have options. What you choose depends on how much you can afford each month, as well as what interest rate you want to pay, and how long you expect to be in debt with the mortgage. (See also: 5 Things Our Realtor Told Us That Weren't True)
Before you begin the process, make sure you understand your mortgage choices, and choose what is likely to work best for you.
Fixed-rate mortgages are popular because they allow homebuyers to plan ahead. With a fixed-rate mortgage, you "lock in" your interest rate for the entire period of the loan. When you have a fixed-rate mortgage, the principal plus interest portion of your payment remains the same for the whole term.
Shorter Term = Higher Payments
Usually, you choose between getting a fixed-rate mortgage for 30 years (most common) or 15 years. Often, you can get a better interest rate if you choose the 15-year fixed-rate mortgage. However, the monthly payments are usually higher. A 30-year loan will cost you more in the long run, but it is also more manageable on a monthly basis. If you are concerned about cash flow, a 30-year loan can be helpful.
Plan for Flexibility
One strategy is to agree to a 30-year mortgage, but make payments as if it's a 15-year mortgage. There will be a higher interest rate on the loan, but paying it off faster means that you save overall. The reason some homebuyers go this route is to retain flexibility. If the higher 15-year payment becomes untenable, the borrower can cut back to the agreed upon 30-year payment.
Adjustable Rate Mortgage (ARM)
The other broad category of loan types is the ARM. With this type of mortgage, the interest rate changes periodically. With the changing interest rate, you are also subject to changing mortgage payments. If the market rates rise, then you will end up with a higher monthly payment. On the other hand, if the market drops, you see a reduction in your mortgage payment.
Rate Resets Mean Unpredictability
Interest rates are usually set by adherence to a particular index. The lender will tell you how the rate is set, and how often it is set. Many rates are set quarterly, semi-annually, or annually. It's common to find an ARM with a rate that sets annually. On a particular day each period, the current rate is used to set your interest charges for the following period. If you are on a semi-annual schedule, your rate will be set for the next six months.
ARMs can make it a challenging to plan your finances, especially if the rate changes every quarter or every six months. It can also be difficult if rates begin rising. With the rate going up regularly, you find yourself paying more and more for your home each month. In some cases, if you remain in your home for the full term of the mortgage, the rate decreases (and subsequently lower payments) are not enough to offset increases. An ARM can be more costly over time than a fixed-rate mortgage, depending on the market conditions.
Low Initial Payments
With an ARM, one of the biggest advantages is that you often start out with an interest rate that is very low. Most ARMs have initial rates that are lower even than a 15-year fixed-rate mortgage. If you think you will move soon, or if you are confident that you can refinance to a fixed-rate mortgage before rates really start rising, an ARM can make sense. You have the advantage of a low rate initially, and as long as you can sell or refinance before a higher rate starts costing you, and ARM can be a good choice.
If you decide to use an ARM, make sure that you find out about interest caps. Many ARMs have caps on the interest rate, which means that you have some measure of protection in the event that interest rates rise dramatically.
A subset of the ARM is the hybrid ARM. This type of mortgage is fixed for a set period of time, and then adjusts after the initial period is up. One common type of hybrid ARM is the 5/1 ARM. With this type of mortgage, your rate is fixed for five years, and then the rate is adjusted each year after that.
It's also possible to get a 7/1 ARM or a 3/1 ARM and lots of other ARMs. Realize, though, that the longer you have a fixed rate, the higher your rate will be. With a 7/1 ARM, you will pay a slightly higher interest rate than with a 5/1 loan. The 3/1, on the other hand, usually has a lower initial interest rate. If you want a lower rate, you have to be prepared to give up a certain amount of certainty.
Loan caps on hybrid loans also operate a little differently. You are likely to see three different types of caps with a hybrid ARM:
- Initial Adjustment: This cap represents the first adjustment made after your initial fixed term is up. If you have a 5/1 hybrid, the cap might be 5%. This means that the lender can add up to 5% to your initial rate in its first adjustment.
- Rate Adjustment: A rate adjustment cap is the maximum adjustment made each period. If you have a cap of 2%, it means that the lender won't adjust your rate up by more than 2% above your current rate at adjustment time — no matter what the market indicates.
- Lifetime: Finally, the lifetime cap represents the highest an interest rate can go. Once you hit the lifetime cap, your interest rate won't go higher.
Depending on your situation, a hybrid ARM with a reasonable cap can be a good choice.
If you are looking for a low initial rate while you start your career, or a business, or if you have variable income, it can make sense to start with a mortgage that has an adjustable rate. However, you need to be prepared for the possibility of higher interest down the road. It makes sense to save extra money, or to refinance when you can to a fixed rate so your payments are more predictable over time.
What type of mortgage do you have? Fixed, adjustable, or hybrid?