When it comes to choosing a mortgage, there are many options to consider. One important decision is whether to go with a fixed-rate mortgage or an adjustable-rate mortgage (ARM). In this article, we will explore the differences between these two types of mortgages and help you decide which option may be best for you.
Fixed-rate mortgages
A fixed-rate mortgage is a loan with an interest rate that stays the same for the entire term of the loan. This means that your monthly mortgage payments will be the same amount each month, making it easier to budget and plan for your future. The most common term lengths for fixed-rate mortgages are 15 years and 30 years, although other terms are available.
Adjustable-rate mortgages
An adjustable-rate mortgage, on the other hand, is a loan with an interest rate that can change over time. The interest rate is typically based on a financial index, such as the prime rate or the London Interbank Offered Rate (LIBOR). The interest rate on an ARM will typically start off lower than a fixed-rate mortgage, but it can increase or decrease over time depending on market conditions.
Differences between fixed-rate and adjustable-rate mortgages
The most significant difference between fixed-rate and adjustable-rate mortgages is the stability of the interest rate. With a fixed-rate mortgage, the interest rate remains the same for the entire term of the loan, while with an ARM, the interest rate can fluctuate. This means that with a fixed-rate mortgage, your monthly payments will always be the same, but with an ARM, your monthly payments may change.
Margins
When considering an ARM, it’s important to understand the concept of margins. The margin is a percentage added to the index rate to determine the interest rate on the loan. For example, if the index rate is 2.5% and the margin is 2%, the interest rate on the loan would be 4.5%. The margin is typically set by the lender and is included in the loan agreement. Your ARM rate can go below a certain margin specified in your loan documents.
Rate caps
Another important factor to consider when choosing an ARM is the rate caps. Rate caps are limits on how much the interest rate can increase or decrease over the term of the loan. There are usually two types of rate caps: periodic caps and overall caps. Periodic caps limit the amount the interest rate can change from one adjustment period to the next, while overall caps limit the total amount the interest rate can change over the life of the loan.
Interest rates
As mentioned above, the interest rate on a fixed-rate mortgage remains the same for the entire term of the loan. This means that the interest rate will be higher than an ARM at the beginning of the loan, but it will not change over time. On the other hand, the interest rate on an ARM will typically start off lower than a fixed-rate mortgage, but it can increase or decrease depending on market conditions.
Ease of qualification
One advantage of a fixed-rate mortgage is that they are generally easier to qualify for than ARMs. This is because the lender knows exactly what the monthly payments will be for the entire term of the loan, making it easier to predict the borrower’s ability to make their payments. With an ARM, the monthly payments can change, making it more difficult for the lender to predict the borrower’s ability to make their payments.
Down payment
The down payment required for a mortgage is typically a percentage of the purchase price of the home. The exact percentage can vary depending on the type of loan and the lender’s requirements. In general, Adjustable-rate mortgages (ARMs) generally require a slightly higher down payment of 5 percent, compared to some fixed-rate conventional loans that may only require a 3 percent down payment.
Term length
The term length of a mortgage is the number of years that the borrower has to pay off the loan. As mentioned earlier, the most common term lengths for fixed-rate mortgages are 15 years and 30 years, although other terms are available. Adjustable-rate mortgages can also have various term lengths, although they are usually shorter than fixed-rate mortgages.
Credit score qualifications
Both types of mortgages generally require a minimum credit score of 620. This is because lenders want to ensure that borrowers have a strong credit history and a stable income, which can indicate their ability to make their mortgage payments on time.
It’s important to note that while a higher credit score may make it easier to qualify for a mortgage, it’s not the only factor that lenders consider. Other factors that may affect a borrower’s ability to qualify for a mortgage include their debt-to-income ratio, their employment history, and their savings and assets. It’s important to work on improving your credit score and to have a clear understanding of your financial situation before applying for a mortgage.
Down payment
The down payment required for a mortgage is typically a percentage of the purchase price of the home. The exact percentage can vary depending on the type of loan and the lender’s requirements. In general, a larger down payment will result in a lower interest rate and a lower monthly payment.
Pros and cons of adjustable-rate mortgages
One of the main advantages of an adjustable-rate mortgage is that the initial interest rate is typically lower than a fixed-rate mortgage. This can result in lower monthly payments at the beginning of the loan. However, the interest rate on an ARM can increase over time, which can result in higher monthly payments down the road.
Pros and cons of fixed-rate mortgages
The main advantage of a fixed-rate mortgage is the stability of the monthly payments. The borrower knows exactly what their payments will be for the entire term of the loan, which can make it easier to budget and plan for the future. However, the interest rate on a fixed-rate mortgage is usually higher than an ARM at the beginning of the loan, resulting in higher monthly payments.
Which should you choose?
Deciding between a fixed-rate mortgage and an adjustable-rate mortgage is a personal decision that will depend on your individual circumstances. If you are planning on staying in your home for a long period of time and want the stability of fixed monthly payments, a fixed-rate mortgage may be the better option. On the other hand, if you only plan on staying in your home for a few years and are willing to take on the risk of fluctuating monthly payments, an adjustable-rate mortgage may be a good choice.
Questions to ask before taking out an adjustable rate mortgage:
Before taking out an adjustable-rate mortgage, it’s important to consider the following questions:
How frequently does the ARM adjust?
The frequency at which an adjustable-rate mortgage adjusts refers to how often the interest rate can change. This can be monthly, annually, or every few years, depending on the terms of the loan. A mortgage that adjusts more frequently may have lower initial interest rates, but it also means that the borrower could potentially face more frequent and larger payment changes.
How long do you plan on staying in the home?
The length of time that you plan on staying in the home is an important factor to consider when choosing between a fixed-rate mortgage and an adjustable-rate mortgage. If you only plan on staying in the home for a few years, an adjustable-rate mortgage may be a good option because the initial interest rate is typically lower. However, if you plan on staying in the home for a longer period of time, a fixed-rate mortgage may be a better choice because it offers the stability of fixed monthly payments.
Can you still afford your payments if rates jump?
It’s important to consider whether you will be able to afford your mortgage payments if the interest rate on your adjustable-rate mortgage increases. This is especially important if you have a tight budget or if you are close to the maximum amount that you can afford to pay each month. If you are concerned about being able to afford higher payments in the future, a fixed-rate mortgage may be a safer choice.
What’s the interest rate environment like?
The current interest rate environment can also be a factor to consider when choosing between a fixed-rate mortgage and an adjustable-rate mortgage.If interest rates are expected to rise in the near future, a fixed-rate mortgage may be a better option to lock in a low rate for the entire term of the loan
As of January 06, 2023 the Federal Reserve interest rate, or federal funds rate, is 4.25% to 4.50% after the recent interest rate hike by 0.50%, the seventh rate hike this year. The current average rate for the benchmark 30-year fixed mortgage is 6.52%, which is over 3% higher than the 52-week low of 3.4 percent. The Fed’s revised script calls for the federal funds rate, the central bank’s benchmark borrowing rate, to move higher, but at a slower pace than in the past several months.
It’s important to keep in mind that no one can predict with certainty what the future interest rate environment will be, so it’s important to weigh the risks and benefits of both types of mortgages before making a decision.
Answering these questions will help you determine whether an adjustable-rate mortgage is right for you.
