Which is the better mortgage option for you: fixed or adjustable?
The low initial cost of adjustable-rate mortgages, or ARMs, can be very tempting to home buyers, yet they carry a degree of uncertainty. Fixed-rate mortgages offer rate and payment security, but they can be more expensive.
Here are some pros and cons of ARMs and their fixed-rate brethren.
All of these things should factor into your decision between a fixed-rate mortgage and an adjustable. But there are other important questions to answer when deciding which loan is better for you:
1. How long do you plan on staying in the home?
If you're only going to be living in the house a few years, it would make sense to take the lower-rate ARM, especially if you can get a reasonably priced 3/1 or 5/1. Your payment and rate will be low and you can build up more savings for a bigger home down the road. Plus, you'll never be exposed to huge rate adjustments because you'll be moving before the adjustable rate period begins.
2. How frequently does the ARM adjust, and when is the adjustment made?
After the initial fixed period, most ARMs adjust every year on the anniversary of the mortgage. The new rate is actually set about 45 days before the anniversary, based on the specified index. But some adjust as frequently as every month. If that's too much volatility for you, go with a fixed-rate mortgage.
3. What's the interest rate environment like?
When rates are relatively high, ARMs make sense because their lower initial rates allow borrowers to still reap the benefits of homeownership. Rates could fall even further, meaning borrowers will have a decent chance of getting lower payments even if they don't refinance. When rates are relatively low, however, fixed-rate mortgages make more sense. After all, 7 percent is a great rate to borrow money at for 30 years.
4. Could you still afford your monthly payment if interest rates rise significantly?
On a $150,000, one-year adjustable-rate mortgage with 2/6 caps, your 5.75 percent ARM could end up at 11.75 percent, with the monthly payment shooting up as well.
|How adjustable rates can rise|
|Year of ARM||Rate||Monthly payment|
|Fourth year (6% lifetime cap)||11.75%||$1,514 ($639 more than first year)|
Now, let's compare this worst-case ARM scenario to a fixed-rate mortgage:
|ARM vs. fixed mortgage as rates rise|
|Interest rate during 4 years||Total payments during 4 years|
|ARM: 5.75% to 11.75%||$57,036|
|Fixed rate: 7.75%||$51,600|
|Savings with fixed-rate mortgage over 4 years: $5,436.|
In the above case, the fixed-rate mortgage costs less than the worst-case ARM scenario. Experts say when fixed mortgage rates are low, they tend to be a better deal than an ARM, even if you only plan to stay in the house for a few years.