Deciding between a fixed-rate mortgage and an adjustable-rate mortgage (ARM) depends on your finances, spending habits and lifestyle. For example, how long do you plan to stay in your home, how confident are you in your knowledge of the economy and can you afford any changes in your monthly mortgage payment? Determining whether a fixed-rate or ARM is right for you depends on a few fairly simple questions, but first, let’s explore, in detail, the difference between the two.
What’s the Difference Between a Fixed-Rate Mortgage and an ARM?
According to the Consumer Financial Protection Bureau, with a fixed-rate loan, the interest rate is set when you take out the loan and will not change. With an ARM, the interest rate may go up or down. With a fixed-rate loan, its principal balance and interest are spread out evenly, over the term of the loan, meaning that the interest rate and monthly payments will remain unchanged. ARMs, on the other hand, are affected by the ebbs and flows of the economy. Current market conditions will directly affect your loan’s interest rate — sometimes positively, sometimes negatively.
Luckily, there are increase caps with an ARM, which protect you from drastic payment changes. However, rates will never be as stable as those that come with a fixed-rate loan. If you have a typical one-year ARM, your annual rate increase may be capped at 2 percent, meaning that your interest rate won’t increase by more than 2 percent over the previous year. Your loan may also have a lifetime adjustment cap, which is typically around 5 percent.
Potential Risks and Rewards
As with any other investment, there are potential risks and rewards that depend on the type of mortgage you move forward with. For example, when you take out a fixed-rate loan, you risk potentially overpaying for the lifetime of your loan, especially if the Federal Reserve keeps interest rates low. Similarly, with an ARM, the risk is due to the uncertainty of the economy. You may initially pay less interest on your loan, but eventually rates could spike, resulting in higher monthly payments than you’d be paying with a fixed-rate loan. The potential reward for both loans options will result in you paying the least amount of interest over the lifetime of your loan. If you plan on refinancing or paying off your loan within the first five years, keep in mind that both fixed-rate and ARM loans can come with prepayment penalties. These penalties can cost you an additional few thousand dollars, so be sure to check with your lender for the specifics of your loan.
Pros and Cons of a Fixed-Rate Mortgage
- Mortgages with fixed rates are predictable because the interest rate is locked down.
- This type of loan is often popular with first-time homebuyers because it is straightforward and easy to understand
- If you lock your mortgage rate in, and the market is bad, you may end up paying too much over the lifetime of your loan.
- If you plan on refinancing or flipping your home, a mortgage with a fixed rate may give you less of an advantage over an ARM because ARMs typically have lower introductory annual percentage rates than fixed rate mortgages.
Pros and Cons of an ARM
- Attractive to homebuyers who know they will only need the loan for a few years.
- With extensive market research, you could end up paying a much lesser amount with an ARM than a fixed-rate loan — but only if the market indicates so.
- Because of the research involved with ARMs, as a first-time homebuyer, the process might be less straightforward than that of a fixed-rate mortgage.
- If interest rates increase after the initial rate period, your payments will also increase.
Choosing a mortgage doesn’t have to be complicated, and by identifying your loan options and what differentiates each, you’ll be able to see which type of mortgage is the best option for you. If you need additional help, reach out to a lender directly to discuss your options, or head to Owners.com for more resources.
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