The mortgage process can be intimidating! There are different types of loans, different structures, and terms that can can have long term financial implications. In this situation, information is power. Understanding your options and how they affect you is the key to making a smart decision that will set you up for success. One of the first decisions to make is the structure of your loan.
Let’s start with a couple of definitions:
A Fixed Rate Mortgage is an agreement to make payments at a certain interest rate for the entire life of the loan.
An Adjustable Rate Mortgage often offers a lower introductory rate that can be raised by your lender after a set period of time.
Fixed Rate Mortgages
Fixed Rate Mortgages are by far the most common in today’s real estate market. As the name suggests, the rates and payments remain constant and don’t depend on the fluctuations of the broader economy.
The advantages of Fixed Rate Mortgages are centered around that stability. A consistent payment structure allows homeowners to manage their money with more predictability because their payments don’t change. For people who like being able to budget for long term purchases, a Fixed Rate Mortgage may be a great option. They are also a good fit for first-time home buyers who may be overwhelmed by the complexity of other types of mortgages.
While Fixed Rate Mortgages work well for most, there are some disadvantages associated with them. In some cases, they are more expensive in the short term because there is no initial payment and rate break. They are also nearly identical for every borrower, so there’s not a lot of customization options. For many, the biggest disadvantage of a Fixed Rate Mortgage is the inability to take advantage of lower rates without refinancing.
Adjustable Rate Mortgages
A lesser-used option, the Adjustable Rate Mortgage, accounts for just 2% – 9% of all loans today. However, they are worth investigating as they have experienced a recent increase in popularity as fixed mortgage rates rise.
Adjustable Rate Mortgages offer advantages to homebuyers who are looking to extend their purchasing power with a low introductory interest rate. Because lenders can use the lower payment when qualifying borrowers, people can buy larger homes than they otherwise might. ARMs also enable borrowers to capitalize on falling rates without the hassle of refinancing. In the case of decreased interest rates in the market, ARMs automatically adjust to the lower payments. Essentially, they offer great options for borrowers who don’t plan on staying in their house forever to capitalize on lower payments.
As you may expect, Adjustable Rate Mortgages have some disadvantages associated with their volatility. While the initial rate may be low, payments can rise significantly over the life of the loan. This is where some borrowers can get in trouble as rates can skyrocket from year to year. Many ARMs feature lifetime caps and other security measures to limit volatility, but it’s important to understand their terms to truly identify how they affect the value of the loan. Those complexities are the biggest disadvantage of an Adjustable Rate Mortgage – they can be extremely difficult to understand.
Which is right for you?
While both types of loans offer different advantages and disadvantages, the key to determining which is right for you depends on a few factors. First, ask yourself how long you plan on staying in your home. If you’re going to be living in the house only a few years, it may make sense to get a low-rate ARM to allow you to save money on your payments. If you plan to move before the adjustable rate period begins, this would enable you to save money for a bigger house down the road.
To that point, another factor to consider is how frequently the ARM adjusts. This can vary from yearly to monthly and is key to evaluating the financial impact of your loan on your budget.
Ultimately, understanding how much volatility you can manage will determine which loan option is best for you!