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Fixed Rate or Adjustable Rate Mortgage?
You've probably found that there are a myriad of mortgages out there--and that the mortgage you choose could save--or cost--you thousands of dollars. But, don't let that overwhelm you. Choosing a mortgage doesn't have to be as complicated as it may appear. A lender can discuss your options and how they might benefit you. There are only a few important things to consider when selecting your mortgage.
What is my current financial situation? How might it change?
How long do I intend to keep this house?
How comfortable would I be with the possibility of my payments increasing?
Keep these things in mind as you consider your mortgage options. And, though there may seem to be a lot of loans on the market, there are really only three kinds of mortgages: fixed mortgages whose interest rates and monthly payments remain unchanged, adjustable mortgages with rates and payments that increase or decrease with the market, and those that fall somewhere in between and are a sort of hybrid of the two first types. The other articles in this section explain the different mortgage types in more depth and also outline which types might suit you.
Fixed Rate Mortgages
You've probably heard of the 30-year fixed rate mortgage. It is the most common type of loan. There are also 15-year (and even 10- and 20-year) fixed rate mortgages which allow you to pay off your mortgage in less time, with less interest. A fixed rate loan is one in which principal and interest are amortized, or spread out, evenly over the term of the loan, so that both interest rate and monthly payments remain unchanged for the life of the loan.
Fixed rate mortgages protect you from the risk of rising interest rates. If interest rates are particularly low when you purchase your new home, or if you expect them to rise, a fixed rate mortgage could be a wise investment. On the other hand, unlike adjustable rate mortgages (ARMs), fixed rate loans won't take advantage of falling rates. Since you're locked into one rate for the life of your loan, you could end up with interest higher than current market rates in the years to come. At that point, however, refinancing might enable you to take advantage those lower rates.
Adjustable Rate Mortgages
Adjustable Rate Mortgages (commonly called ARMs) are flexible loans with interest rates and monthly payments that rise and fall with the economy. With an adjustable loan, the borrower shares in the benefits and risks of having the loan tied to market changes. Because the borrower shares in the risk of rising rates, lenders are able to offer lower initial interest rates than on fixed rate mortgages. The interest rate on your loan is then adjusted periodically according to whatever market index you chose when selecting your ARM.
Interest rate and monthly payment can change every six months, once a year, every three years, or every five years. For example, a one-year ARM has an adjustment period of one year, which means that the interest rate and monthly payment can change once a year. The frequency and dates of adjustments are established when you apply for your loan.
The interest rate on an adjustable mortgage changes according to a financial index. You may choose an ARM tied to any one of a variety of market indexes, such as CDs, T-Bills, or LIBOR rates. When your interest rate is up for adjustment, your lender will take the current rate of the index to which your loan is tied and add a margin, a certain set number of interest points laid out in your loan agreement, to determine your new rate. So, your interest rate and monthly payments could increase or decrease over the life of your loan, depending on the activities of the market.
Caps set forth in your loan agreement limit the amount by which the interest rate can increase at each adjustment. And ceilings, or lifetime caps, limit the total rate increase over the life of the loan. So, if you have a typical one-year ARM, your annual rate increases may be capped at 2%, which means that your interest rate can never increase by more than 2% over the previous year. Separately, your loan may have a lifetime rate cap of 6%. So, if you had an initial interest rate of 5%, the highest interest rate you could ever pay would be 11%. Caps protect you from drastic changes in interest rate, but do not guarantee you the stability of a fixed rate loan. With an ARM, you exchange the possibility of lower interest rates for the possible risk of rising rates.
An ARM might benefit you in several ways. ARMs usually come with initial interest rates that are 2-3 points lower than those on comparable fixed-rate mortgages. The lower initial interest rate can help you qualify more easily and afford the house you want to buy. You will most likely qualify for a larger loan with an ARM than with a fixed rate mortgage. You might also want to consider an ARM if you plan to move in a few years, so you are not concerned about the possibility of rate and payment increases. If you plan to move within 5 years, a 5-year ARM would even give you the advantages of a lower interest rate with none of the risks. And, even if you plan to live in your new home for longer, it might be safe to take the risks involved in an ARM if you expect your income to increase enough to cover potential increases in payments, or if you expect rates to fall.