Fixed Rate Vs. Adjustable
When looking for a home, the amount of choices and decisions a homebuyer must make can feel overwhelming. The process starts with choosing a real estate agent, to choosing a home, to deciding what to offer for the home…..the list goes on and on. Finally the perfect house is found and what is the buyer faced with? Mortgage decisions!
Now, with mortgages, there are actually a lot of choices and decisions to be made; but for the purpose of this article, I will break it down as simply as possible. The biggest decision to make as far as a home mortgage goes is whether to choose a fixed rate mortgage or an adjustable rate mortgage (ARM). A good mortgage loan officer will carefully go over the risks and benefits of each option and help tailor a mortgage to your particular wants and needs. In the meantime, though, I’ll explain the main differences between the two.
A fixed rate mortgage is a great mortgage to have for a homebuyer looking to stay in his/her home long term. By long term, I mean at least ten years or more. With a fixed rate loan, the principle and interest payment never changes, so this allows for better personal financial planning. For a thirty year fixed rate mortgage, your payment will be the same all 360 months of the mortgage, until the home is paid off. This steady, predictable payment schedule is ideal for long term budgeting, but if they buyer ends up selling the home or refinancing at any time, they may regret having gotten into a fixed rate mortgage. The reason is because fixed rate mortgages are slightly higher in interest rate compared to an adjustable rate mortgage.
It has been said that on average a homeowner in the United States stays in their home for about seven years. Job transfers, fluctuations in income, family additions and other factors give cause to borrowers upgrading or downgrading into homes that are more suitable to their new wants and needs. If a buyer has in mind a specific time period that they will be in the home, he or she may want to consider an adjustable rate mortgage.
There are many different types of ARMs, and they each have their own rules of adjustment. Basically, an ARM has two parts to it: the introductory fixed rate section and the adjustable section. A borrower can choose the fixed rate section that they prefer. For example: I recently had a client who was buying a home. His job had transferred him to the Phoenix area but he was close to retirement age. He said that he was going to retire within five years and then move to a location close to the ocean. Because of his five year plan, I gave my client estimates on a 5-year ARM and 7-year ARM.
Most ARMs are amortized over 30 years. The 5-year ARM is fixed for the first five years of the loan and then becomes adjustable for the final 25 years. A 7-year ARM is fixed for the first seven years, then becomes adjustable for the final 23 years. The longer the fixed portion of the ARM, the higher the interest rate. So, the quote that I provided for my borrower had a higher interest rate on the 7-year ARM by about .125%. The 5-year ARM was also lower than that day’s 30-year fixed rate by .625%. This means that if the borrower had chosen a 30-year fixed rate and moved in five years, he would have wasted .625% of his payment each month. The savings he gained by choosing the 5-year ARM translated into a savings of $120 per month!
Another point about ARMs is that because they have a lower interest rate initially, a borrower will be able to qualify for a higher purchase price. Buyer’s should beware, however, because once the fixed rate portion of the ARM expires the interest rate can start to climb, making the buyer’s monthly payment rise along with it. The borrower will either have to sell the home or incur the expense of a refinance to lock into a fixed rate at that time.
