When making a decision on which type of home loan is right for you, the options can be confusing and overwhelming. It’s important to understand the pros and cons of each loan program and interest rate options to strategically structure a loan that will work best for your unique situation.
In this post, we discuss the basic differences between a fixed and adjustable rate mortgage (ARM) and what you should consider when picking the option that’s best suited to your long-term goals.
Fixed Rate Mortgage
A fixed rate mortgage has an interest rate that does not change over time. This means that if you’re approved for a home loan at 4.0%, your loan will remain at this rate for its entire duration, unless you choose to refinance. Despite changes in the market, there will be no variance in your rate. This is a long-term plan that typically benefits individuals who intend to own for more than ten years or for those who are purchasing when rates are historically low.
Fixed rate mortgages typically have higher payments than adjustable rate mortgages, however, you may still choose a fixed rate simply because you want to remove all future interest rate risk. Although fixed rate mortgages are the most common program in the U.S., these programs do not always benefit every borrower.
Myth: An adjustable rate mortgage changes every month.
Fact: An adjustable rate mortgage (ARM) is a loan that is fixed for an initial period of up to ten years before it enters its adjustment period, where the interest rate adjusts once per year.
Adjustable Rate Mortgage
An adjustable rate mortgage is a loan that is fixed for an initial period before it begins to adjust. Once an adjustment period begins, your rate is calculated using an index (according to Investopedia, in most cases, mortgages are tied to one of three indexes: the maturity yield on one-year Treasury bills, the 11th District cost of funds index, or the London Interbank Offered Rate aka LIBOR) added to a set margin (i.e. 2.25%).
The exact index and the margin are characteristics of a specific loan and are delineated upfront when you select your loan program. ARM loans are typically quoted as “7/1” The number before the slash is the length of the initial fixed period in years. The number after the slash is how often the rate will adjust after the initial fixed period has ended.
By understanding how and when ARMs adjust, there is a certain degree of certainty. To avoid significant variations in your payments, there are also caps to ensure your interest rate does not adjust too dramatically. These caps are typically quoted with three numbers, ex. “2/2/5.” The first number (2) is the maximum change in interest rate upon the first adjustment. The second number (also 2 in this example), is the maximum change in interest rate after the first adjustment. The third number (5), is the maximum increase in interest rate above the starting interest rate. In the event the index ever went negative, the minimum interest rate is typically the margin.
When considering an ARM, in addition to the initial rate, it is important to have clarity around the index, margins, and caps that will affect your payment if you ever enter the adjustment period. Although interest rates and monthly payments are initially lower than a fixed mortgage, this doesn’t mean you should use an ARM to acquire a more expensive house since that could have other considerations such as down payment and reserves, or the possibility that you are unable to sell the home if the interest rate becomes more than you can afford after the adjustment period.
Did you know that Neat allows you to digitally compare different loan scenarios side-by-side in your home loan application
Is an ARM the Right Choice?
Adjustable rate mortgages are often strategically used by homebuyers with short term timing, strong assets to pay back their loan, or for cash flow management purposes. ARMs are riskier loans because you can’t always predict what direction rates will go when an adjustment period comes into play. Generally, the less time your loan is in an adjustment period, the more certainty you’ll have. While you may save during the time period before your rate adjusts, should the adjustment move to a much higher rate, you could end up paying significantly more later in the life of your loan.
Taking a Long-Term View
The difference between a fixed and adjustable rate mortgage is the rate variability or lack thereof. Rates on ARMs will go up or down, while fixed rate mortgages will remain constant throughout the entire life of the loan. Both loan types offer varying degrees of savings and certainty.
When working with a lending expert, be sure to review both options to ensure you’re getting the best loan structure to fit your goals. The more you know about each, the easier it will be to formulate the loan program and terms that work in your favor.