You’re
shopping for a house. You’ve done your
homework researching rates, terms, different lenders, etc. But, did you look at different loan options
as well? How do you decide if a fixed
rate or adjustable rate mortgage is right for you? There are pros and cons to both fixed rate
mortgages and adjustable rate mortgages (ARMs).
The loan that makes the most sense for you will depend on your
preferences, financial standing, and future plans.
First let’s
look at the difference between fixed and adjustable rate mortgages. Fixed rate mortgages have an interest rate,
and therefore a monthly principal and interest (P&I) payment, that remains
the same over the life of the loan. An
adjustable rate mortgage, as the name suggests, means that the interest rate
can fluctuate over the life of the loan, according to the variables laid out in
your original loan agreement. (For
details on understanding adjustable rate mortgages, refer to this
post).
With both loan types, you can
generally choose a term that fits your needs – 10, 15, 20, 30 years. Assuming that you’d be shopping for a loan
term of 30 years, here are some factors to consider.
1.
How long
do you plan to stay in your home (or mortgage loan)?
Many people do not plan to stay in their homes or mortgages
long enough to make a fixed rate loan worthwhile. On average, homeowners move every 8-10 years
and refinance their mortgage even more often than that. If this sounds like you, you may want to
consider an adjustable rate mortgage over a fixed rate mortgage. Rates on fixed rate mortgages tend to be
somewhat higher than the initial rate on adjustable rate mortgages. This is because when the loan is written the
lender assumes that you will take the full 30 year term to pay the loan
back. If rates go up over the lifetime
of the loan, the lender may end up losing money. If you do not plan to stay in your home long
enough to see the interest rate change on your adjustable rate mortgage, if you
expect to refinance your loan in 5 to 10 years, or if you can afford a slight
increase in your P&I payment for a year or two before you move, why pay
extra interest up front for the reassurance of a fixed rate loan you’re not
going to keep long enough to enjoy?
2.
What are
the trends with interest rates?
If you expect rates to increase over the term of your loan,
then it may make sense to lock in a low fixed rate today. However, if you if you opt for the fixed rate
and interest rates later fall, you will have to refinance in order to lower the
rate on your mortgage, paying closing costs all over again. An adjustable rate mortgage, on the other
hand, allows your interest rate to adjust to the market, so if rates stay low
or drop, the same could happen to the rate on your mortgage without the hassle
of refinancing. Many people worry that
if they opt for an adjustable rate mortgage and rates increase, they will start
out paying 3% and end up paying 20%. In
reality, if you choose a good adjustable rate mortgage, you do have some protection. Your ARM will come with rate caps, both for each
adjustment and for the lifetime of the loan, to prevent sudden, astronomical
rate hikes. This ties into the first
point as well, since the longer you plan to stay in your home, the more
uncertainty there is in predicting interest rates.
3.
How do
you budget?
If your monthly housing budget is very tight and you would
not be able to afford even a small increase to your monthly principal and
interest payment, the fixed rate loan probably makes more sense even if it will
cost you a bit more or you do not plan to stay in the home for a full 30
years. However, you should consider that
a fully escrowed payment on a fixed rate loan could still change. The P&I payment will remain the same, but
varying tax and insurance costs over the time you own your home can still lead
to changes in your total monthly payment.
Conversely, if you can budget for changes in your principal and interest
payment then the up-front savings of an ARM may make up for payment increases
down the road, especially if you use the initial savings to pay down the loan
faster. Each adjustment to the payment
is calculated based on the remaining principal loan balance at that time,
rather than the initial amount borrowed.
So if you pay your loan down ahead of schedule, you could end up enjoying
decreasing monthly payments even if your interest rate increases slightly!
4.
How much
flexibility do you want or expect?
Most fixed rate loans are sold to the secondary market,
meaning that while you might get your loan at XYZ Credit Union or ABC Bank, it
will probably ultimately end up being owned and serviced by Fannie Mae or
Freddie Mac. This results in essentially
a “standard” fixed rate loan that varies very little from one financial
institution to another; whereas institutions often retain adjustable rate
mortgages on their own books. This
allows for greater flexibility and customization of adjustable rate
mortgages. Even something as simple as
splitting your mortgage payment into two bi-weekly payments in order to reduce
the amount of interest you pay can be difficult (or cost money) when your loan
is sold to the secondary market.
The loan
type that is right for you is going to be totally subjective and will depend a
lot on how you expect the future to play out.
The most important thing you can do in shopping for a mortgage loan is
get the facts straight. Make sure that
you understand all the terms you’re being quoted, and what they actually mean
in regard to how your loan will behave.
As final
food for thought, here is a scenario that was put together by Freddie Mac to
compare the costs of fixed rate loans versus adjustable rate loans:
In January 2003 the average fixed rate
mortgage came in at 5.92%. For a loan of
$200,000 the principal and interest payments for 10 years would have cost you
$142,660. However, an ARM that adjusted
annually had an initial rate of 3.99%.
Even after recalculating the interest rate each year, the total amount
paid in principal and interest for that same loan and time period came to only
$119,181 – a savings of over $23,000! The
adjustments on the ARM loan did increase the rate to 5.47% at its peak, but
that is still lower than the 5.92% you would have paid on the fixed rate
loan. And, at one point the ARM rate
fell to 2.76%.
