Which is the better mortgage option for you:
fixed or adjustable?
The low initial cost of adjustable-rate mortgages,
or ARMs, can be very tempting to home buyers, yet they carry a degree
of uncertainty. Fixed-rate mortgages offer rate and payment security,
but they can be more expensive.
Here are some pros and cons of ARMs and their fixed-rate
brethren.
Adjustable-rate mortgages
Advantages
Disadvantages
•
Feature lower rates
and payments early on in the loan term. Because
lenders can use the lower payment when qualifying
borrowers, people can buy larger homes than they
otherwise could buy.
•
Allow borrowers to
take advantage of falling rates without refinancing.
Instead of having to pay a whole new set of closing
costs and fees, ARM borrowers just sit back and
watch the rates -- and their monthly payments --
fall.
•
Help borrowers save
and invest more money. Someone who has a payment
that's $100 less with an ARM can save that money
and earn more off it in a higher-yielding investment.
•
Offer a cheap way
for borrowers who don't plan on living in one place
for very long to buy a house.
•
Rates and payments
can rise significantly over the life of the loan.
A 6 percent ARM can end up at 11 percent in just
three years if rates rise sharply.
•
The first adjustment
can be a doozy because some annual caps don't apply
to the initial change. Someone with an annual cap
of 2 percent and a lifetime cap of 6 percent could
theoretically see the rate shoot from 6 percent
to 12 percent 12 months after closing if rates in
the overall economy skyrocket.
•
ARMs are difficult
to understand. Lenders have much more flexibility
when determining margins, caps, adjustment indexes
and other things, so unsophisticated borrowers can
easily get confused or trapped by shady mortgage
companies.
•
On certain ARMs,
called negative amortization loans, borrowers can
end up owing more money than they did at closing.
That's because the payments on these loans are set
so low (to make the loans even more affordable)
they only cover part of the interest due. Any additional
amount due gets rolled into the principal balance.
Fixed-rate mortgages
Advantages
Disadvantages
•
Rates and payments
remain constant. There won't be any surprises even
if inflation surges out of control and mortgage
rates head to 20 percent.
•
Stability makes budgeting
easier. People can manage their money with more
certainty because their housing outlays don't change.
•
Simple to understand,
so they're good for first-time buyers who wouldn't
know a 7/1 ARM with 2/6 caps if it hit them over
the head.
•
To take advantage
of falling rates, fixed-rate mortgage holders have
to refinance. That means a few thousand dollars
in closing costs, another trip to the title company's
office and several hours spent digging up tax forms,
bank statements, etc.
•
Can be too expensive
for some borrowers, especially in high-rate environments,
because there is no early-on payment and rate break.
•
Are virtually identical
from lender to lender. While lenders keep many ARMs
on their books, most financial institutions sell
their fixed-rate mortgages into the secondary market.
As a result, ARMs can be customized for individual
borrowers, while most fixed-rate mortgages can't.
Chapter 2: How mortgages work
