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Adjustable-rate mortgages, or ARMs, versus fixed-rate mortgages

Consumers should take a 30-year fixed-rate mortgage if they do not like the uncertainty associated with a variable interest rate, says Bob Walters, chief economist at Quicken Loans in Livonia, Mich.

"It makes sense for those people to lock that fixed rate in," he says.

During the housing boom, adjustable-rate mortgages, or ARMs, were popular with flippers and homeowners who wanted to turn a quick, easy profit as home prices soared.

But during the ensuing housing bust, many of the speculators vanished or got stuck with ARMs they couldn't afford, as did unwitting homeowners.

ARMs are popular with homeowners who don't plan to stay in their homes for more than a few years or borrowers with substantial financial resources who can repay the loan before the rate resets.

"There's no sense paying for 30 years (for a fixed-rate loan) when you only need money for five years," says Walters.

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ARMs have an initial period of one or more years where the interest rate is fixed. During the introductory period, the interest rate is typically lower than that of a comparable fixed-rate loan, thereby making initial monthly payments lower.

After the introductory period, the interest rate adjusts and can move up or down, depending on the short-term index it's pegged to -- usually the one-year Treasury or a short-term LIBOR index.

ARMs vs. fixed-rate mortgages
ARMsFixed-rate mortgages
Pros
  • Lower payments early in the loan term.
  • Advantageous for borrowers who don't plan to stay in the same home too long.
  • Interest is tax-deductible.
  • Certainty and security for homeowners who plan to stay in the home for several years.
  • Interest is tax-deductible
  • Amortization table can tell you how much equity you'll have decades into the future.
Cons
  • After the initial fixed-rate period, interest rate can rise significantly.
  • Can be difficult to understand, leaving less savvy borrowers vulnerable.
  • Homeowners with ARMs who had planned to move within a few years may be unable to sell their homes during a housing downturn (and may be unable to make larger payments when the rate adjusts upward).
  • On certain option ARMs, borrowers may end up in a negative amortization situation, owing more on the home than at closing.
  • Higher interest rates.
  • Even if interest rates head lower, yours will stay the same.

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