Types of mortgages
-- adjustable vs. fixed
Which is the better mortgage option for you: fixed
The low initial cost of adjustable-rate mortgages
(ARMs) can be very tempting to home buyers, yet they carry a great
deal of uncertainty. Fixed-rate mortgages (FRM)
offer rate and payment security, but they can be more expensive.
Here are some pros and cons of
ARMs and FRMs.
- Feature lower rates and payments early on
in the loan term. Because lenders can use the lower payment when
qualifying borrowers, borrowers can purchase 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 their rates fall.
- Help borrowers save and invest more money.
Someone who has a payment that's $100 less with an ARM than with
a FRM for a couple of years 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.
- A borrower's initial low rate will adjust to a
level higher than the going fixed-rate level in almost every case
even if rates in the economy as a whole don't change. That's because
ARMs have initial fixed rates that are set artificially low.
- 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.
- 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.
of these things should factor into your decision between a fixed-rate mortgage
and an adjustable one. But there are other important questions to answer when
deciding which loan is better for you:
How long do you plan on staying in the home?
you're only going to be living in the house a few years, it would make sense to
take the lower-rate ARM, especially if you can get a reasonably priced 3/1 or
5/1 ARM. Your payment and rate will be low and you can build up more savings for
a bigger home down the road. Plus, you'll never be exposed to huge rate adjustments
because you'll be moving out before the adjustable rate period begins.
2. How frequently does
the ARM adjust, and when is the adjustment made?
After the initial fixed period, most ARMs adjust every year on the anniversary
of the mortgage. The new rate is actually set about 45 days before the anniversary,
based on the specified index. But some adjust as frequently as every month. If
that's too much volatility for you, go with a FRM.
3. What's the interest rate environment like?
When rates are relatively high, ARMs make sense because their
lower initial rates allow borrowers to still reap the benefits of homeownership.
The chances are fairly good that rates will fall down the road too, meaning borrowers
will have a decent chance of getting lower payments even if they don't refinance.
When rates are relatively low, however, FRMs make more sense. After all, 7 percent
is a great rate to borrow money at for 30 years!
Could you still afford your monthly payment if interest rates rise significantly?
On a $150,000, 1-year adjustable-rate mortgage with 2/6 caps,
your 5.75 percent ARM could end up at 11.75 percent.
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$1,514 ( $639 more than first year)
let's compare this worst-case ARM scenario to a fixed-rate mortgage:
ARM: 5.75% to 11.75%
Fixed rate: 7.75%
with FRM over 4 years: $5,436
In the above case, the fixed-rate mortgage costs less
than the worst-case ARM scenario. Experts say when fixed mortgage rates are low,
they tend to be a better deal than an ARM, even if you only plan to stay in the
house for a few years.
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