Mortgage Basics
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ARM vs. fixed-rate mortgage

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

  • 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.

Disadvantages

  • 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 a year& 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) that they cover only part of the interest due. The remainder gets rolled into the principal balance.

Fixed-rate mortgages

Advantages

  • 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.

Disdvantages

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  • 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 on the secondary market. As a result, ARMs can be customized for individual borrowers, while most fixed-rate mortgages can't.

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