Fixed Rate Mortgages versus Adjustable Rate Mortgages
Whether you are purchasing or refinancing, the loan you choose will either be a fixed rate mortgage and an adjustable rate mortgage (ARM). A fixed rate mortgage is a loan in which the interest rate on the note remains the same throughout the length of the loan. Conversely, the interest rate of an ARM may fluctuate periodically to reflect market conditions. Each has its own benefits and drawbacks, and our mortgage professionals are here to determine which is right for you.
Fixed Rate Mortgages
The main advantage of a fixed rate mortgage, as opposed to an ARM, is that the borrower will never have to pay more than the specified monthly payment - regardless of sudden and potentially significant rises in interest rates. Additionally, having a fixed rate allows borrowers to budget more easily.
Fixed rate mortgages can vary in duration; however, the two most common are 30-year mortgages and 15-year mortgages. Below are some considerations when deciding between the two.
- Higher monthly payments
- Pay significantly less interest over life of loan, building equity faster
- Generally, lower interest rates with 15-year loan products
- Lower monthly payments
- Pay more interest over life of loan
- Generally, higher interest rates with 30-year products
Adjustable Rate Mortgages
Many borrowers feel more secure with fixed rate mortgages, knowing the interest rate will remain the same for the term chosen. However, adjustable rate mortgages have features that may make it a good fit for certain borrowers.
The main advantage of an ARM is that it tends to give the borrower a lower interest rate initially than a fixed-rate mortgage. ARMs have an introductory interest rate that lasts a set period of time and adjusts annually thereafter for the remaining time period. The set rate for ARM loans can last for 3, 5, 7, and 10 years. For example, a 3-year ARM loan is a loan with a fixed rate for the first three years and then the rate changes once each year for the remaining life of the loan.
This type of loan is best for borrowers who plan to sell their home or refinance before the initial lock expires.
The details of a particular ARM, which is called the interest rate cap structure, tell you just how high your monthly payment could go. For example, a 5/1 ARM might have a cap structure of 2-2-6, meaning that in year six (after the introductory period expires) the interest rate can increase by 2%, in subsequent years the interest rate can increase by an additional 2%, and the total interest rate can never increase by more than 6%. Thus, if your introductory rate was 3.5%, your ARM would never adjust higher than 9.5%.
Unfortunately, the financial industry is forever fluctuating. Rates and payments have the potential to rise significantly over the life of the loan. ARMs can be risky if property values go down and borrowers can't sell or refinance.
On certain ARMs, called negative amortization loans, borrowers can end up owing more money than they did at closing. That's because the payments on these loans are set so low (to make the loans even more affordable) that they cover only part of the interest due. The remainder gets rolled into the principal balance.
Given the complexities of these two loan structures, it is vital that borrowers discuss this in-depth with our mortgage professionals. We will evaluate your particular financial situation and make recommendations accordingly. Contact us today!