Deciding Between a Fixed Rate or Adjustable Rate Mortgage

The recent shortage of homes for sale, and the bidding wars for the few homes that reach the market, can create a sense of uncertainty for buyers.

The house prices are almost 20% higher than a year ago, and mortgage rates reflect the current housing market. However, buyers still have the opportunity to lock in historically low interest rates on their mortgages.

While cash sales are about 36% On the market, most homes are bought with mortgage loans. If you are looking to buy a home with the help of a mortgage, it is important to determine whether a fixed or adjustable rate mortgage is the best.

Like the houses themselves, the right mortgage for you depends on what you need and your unique situation. This often depends on your aversion to risk and how long you plan to stay in the house.

Fixed rate mortgages

The most common type of mortgage is a fixed rate mortgage. With this type of loan, the interest rate remains the same for the life of the loan.

A fixed rate means there is no variability in the amount of interest you must pay, and that predictability is great for cash flow planning purposes. Even if the interest rate environment changes and mortgage rates start to rise, yours will remain locked in.

This makes a fixed rate mortgage an excellent option for those who have a fixed income, have an inflexible budget, or simply do not have a high tolerance for financial risk. You know what you are getting into and if you can afford the monthly payments.

Of course, there are downsides to a fixed rate mortgage, because interest rates in the general market don’t just go up. If mortgage interest rates drop, yours remains fixed. That could leave you with a more expensive loan than a newer mortgage.

People often think that they can refinance if this happens. Sometimes that is a good option. But not always worth refinancing, so this is not a foolproof solution.

But at the end of the day, the predictability of having the same monthly payments for the entire term of the loan makes a fixed-rate mortgage a very popular option with home buyers.

Adjustable rate mortgages (ARM)

An adjustable-rate mortgage (also known as an ARM) is a loan with an interest rate that is essentially the opposite of a fixed one – the rate adjusts periodically as market interest rates fluctuate.

The amount of monthly principal you owe on the loan generally does not change, except when you pay it off. The term or duration of the loan is also not adjusted. The interest rate is the only item that is subject to external forces beyond your control that propel it up or down, and that affects your total monthly payment.

Most ARM rates are adjusted annually, although some are adjusted more frequently. (Other time periods may include monthly, quarterly, or semi-annual adjustments.) You will need to dig into the fine print of the specific loan offered by your lender to make sure you understand the timing in which the interest rate can change before committing to an arm.

The initial rate of an ARM is usually set by using an agreed rate or index, such as LIBOR or the Treasury index. The lender can also add a certain amount of margin as a fee for providing you the money in the first place.

While it may seem like an ARM is all-risk just for a potential reward, the terms of the contract can make it a calculated risk where you’re not subject to the whims of the mortgage interest rate gods.

For example, most ARMs include an interest rate cap as part of the terms of the contract. Caps limit the amount of interest rate adjustments, both increases and decreases. An ARM contract can also specify a lifetime limit, which indicates that an interest rate does not go above or below certain percentages.

However, keep in mind that if you have an ARM that limits the amount of your monthly payment, the interest you must pay can be added to the principal itself.

Let’s say you are paying less than the accrued interest rate due to a monthly payment limit. But then the interest rate goes up, causing your payment to go over the limit. It does not come out completely blameless; the unpaid interest simply becomes part of the total loan. This increases your balance, even if you have made your monthly payments.

Traditional ARMs can be beneficial to buyers if certain items fit into place. The initial interest rate on an ARM is generally lower than a fixed rate mortgage, which can help you save money on your loan, at first.

The initial rate is also called a “teaser rate” for a reason: It is likely to change during the first adjustment period and often increase.

People with a very flexible budget may find that the interest rate is worth the risk of a rising interest rate. It might also make sense to get an ARM and take advantage of a lower initial interest rate if you don’t plan on living in the house for a long time.

Most people who use a conventional ARM do so with the intention of refinancing or selling the property in a couple of years. But there is another type of ARM option that might make more sense because it could still give you that option with a slightly lower risk of sticking with a high interest rate.

Adjustable rate hybrid mortgages

Although fixed-rate mortgages and ARMs are the most common, hybrid ARMs can offer a “best of both worlds” solution for some home buyers.

Hybrid ARMs start with a fixed interest rate for a set period of time (typically one to ten years) before becoming a traditional ARM contract. The longer the initial term, the higher the interest rate will be during that time period.

The initial fixed interest rate is still generally lower than a traditional fixed rate mortgage, but the initial rate for hybrid ARMs is generally not as low as that of conventional ARMs.

Hybrid ARMs work well for people who hope to earn a higher income in the future, but want to find a way to secure a more affordable mortgage payment in the short term. This is very common when people upgrade from their first home to their second home. The idea is that you take advantage of the lower temporary fixed rate until you can refinance into a fixed rate mortgage at a later date.

This is a particularly important concept when buying a home in a competitive market. When shopping for a home on a seller’s market, you can easily find yourself stretching your budget to buy the home you want. The lower starting rate of a hybrid ARM can help you get into a more expensive home, as long as you can sell or refinance before the “adjustable” part kicks in and you risk your variable rate going up.

Choosing the right mortgage

If you are risk averse and looking for simplicity, the fixed rate mortgage is probably the best option. However, if you’re willing to take a little more risk, perhaps some type of ARM (conventional or hybrid) could work for you. Your personal circumstances and goals will also help determine the correct choice.

When evaluating the risk spectrum with home loans, it is important to understand whether the interest rate savings are significant enough to justify taking the incremental risk of a traditional or hybrid ARM. The difference between setting a rate that is 0.25 percentage points lower is much less significant than obtaining a rate that is one percentage point lower.

Not everyone has the same level of comfort with risk. Consider which option really fits your lifestyle before making a decision about the type of home loan to get from a lender.

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