Fixed Rate Mortgages vs Adjustable Rate Mortgages (ARM)?
Mortgages aren’t one size fits all. To pick the right one for you, it’s important to understand what makes them different, since there are many products and programs.
Your Emerald Home Loans Consultant will help you choose which is best for your specific scenario. But first, it’s important to have working knowledge of the basics.
In this video, we will focus on two different kinds of mortgages, the fixed rate and adjustable rate mortgage.
A Fixed Rate Mortgage is just what it sounds like. It’s a mortgage where the rate is fixed for the entire life of the loan which is typically 15 years, 20 years or most commonly 30 years.
So, let’s say you take out a 30-year Fixed mortgage with a $2,000 monthly payment of principle and interest this year. You’ll be making that same monthly payment for the entire 30 years.
Then, there are Adjustable Rate Mortgages also known as ARMs. These have interest rates that can change based on market conditions, so your monthly payment can go up or down.
Most ARMs are hybrids which means they have an initial fixed-rated period, after which the interest rate begins to change, usually once per year. You may see this written as 5/1 or 7/1. This means that you get 5, or 7, years of a fixed interest rate, and after that, the interest rate — and your payments — will be adjusted every year based on the remaining balance at that time.
When your interest changes, it's possible that your payments could become so expensive, that you can't keep up with the payment. In this case, an ARM may not be a good choice for you.
So, which of these loan types is best for you? Ask yourself these questions:
- Do you want or need a predictable payment?
- Are you planning to stay in your home for a long period of time?
- Is protecting yourself from rising interest rates in the future important to you?
- Is it improbable that you will be paying off, or down, the loan in the next 5-10 years?
If you answered “Yes” to any of these questions, a Fixed Rate mortgage may be best for you. It will offer you the predictability and stability you need for long term planning.
Who can benefit from an ARM?
THE SHORT-TERM HOMEOWNER: An ARM is an excellent choice if a lower payment and a lower rate of interest in the near term is important to you or if you don’t plan to live in the property long enough for the rates to rise.
Let’s say the interest-rate environment means you can take out a 5-year ARM with an interest rate of 3.5%. A 30-year fixed-rate mortgage, in comparison, would give you an interest rate of 4.25%. If you plan to move before the 5-year ARM resets, you will save a lot of money on interest with a 5 Year ARM.
If, on the other hand, you ultimately decide to stay in the house longer, especially if rates are higher when your loan adjusts, then the mortgage is going to cost more than the fixed-rate loan would have in the long run.
THE PAY-IT OFF TYPE: An ARM is attractive to borrowers who have, or will have, the cash to pay off or pay down substantially the loan before the new interest rate kicks in.
Take for instance, a borrower who is buying a new home and needs to sell their current home. He or she may be forced to purchase the new home regardless of the other not being sold. As a result, the borrower will end up taking out a larger loan than they ultimately need.
Once the borrower has the proceeds from the sale, he or she can then pay down the ARM. If the borrower keeps the loan past the initial adjustment period, the new rate will adjust to the amount owed on the loan.
So, even if the rate goes up, the payment may go down because of the lower loan balance. Interest is charged on mortgages daily based on what you owe; if you considerably pre-pay your mortgage, it may make sense to have a lower rate in the beginning when you owe more. This is a good strategy for borrowers who will come into money or receive large bonus income in the future.
Employing pre-paying strategies are effective ways to accelerate the pay-down of a loan and will save a lot of interest. However, they can be risky, because life happens, and while you may be able to afford to make accelerated payments now, if you get sick or lose your job, that may no longer be an option.
THE BUMP-UP INCOME EARNER: For people who have a stable income, but don’t expect it to increase dramatically, a fixed-rate mortgage may be the way to go. However, if you expect to see an increase in your income, going with an ARM could save you from paying a lot of interest over the long haul.
Let’s say you are looking for your first home and just graduated from medical or law school, chances are high that you are going to earn more in the coming years and can afford increased payments when your loan adjusts to a higher rate. In this case, an ARM is a good choice for you.
Regardless of the loan that you select, choosing carefully will help you avoid costly mistakes. One thing is for sure: don’t go with the ARM because the lower monthly payment is the only way to afford that dream house. You may get a similar rate at the time of reset, but it is a gamble. It’s more prudent to search for a place with a smaller price tag instead.
Let an Emerald Home Loans Representative assist you in the process to make sure you are making the right decision. There are other characteristics that differentiate ARMs from other mortgage products, so reach out to an EHL representative to continue your education path.
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