If you’re planning to buy a new home, refinance your current one or take out a second mortgage, you will have to decide between a fixed-rate and an adjustable-rate mortgage, or ARM.
Which type is the best for you? As the name implies, fixed-rate mortgages are home loans with an interest rate (and payment) that remains the same over time. With this loan, you pay the same amount every month for the entire life of the loan, generally 15 or 30 years.
In the beginning, the portion of your monthly payment going toward interest will be high, and the portion going toward principal payment will be low. This will provide you with a better break on taxes early on. The interest portion of the monthly payment tapers off over the term and the principal portion rises to compensate, but the total payment amount does not vary.
Choosing the right loan
Payments over the total term of an ARM will vary by design. The interest rate usually starts off low (thus the attraction), but it can later rise. If you opt for an ARM, you will pay a fixed interest rate for a predetermined time period (usually five years or less), followed by periodic rate adjustments for the remainder of your loan’s term. This rate is normally a set number of points over a widely published rate, such as the London Interbank Offered Rate, or Libor. If that rate rises (or falls), so do your monthly payments.
The benefit of fixed-rate mortgages is that are no surprises. Your initial payment on the home equals your final payment. For many borrowers, this provides peace of mind in an unpredictable economy. It also is a good strategy when rates are low but likely to rise.
On the flip side, the interest rate on fixed-rate mortgages is typically higher than an ARM’s initial interest rate. If you expect to move or trade up in a few years, this means you will pay more than necessary for a short-term investment — money that you could have invested elsewhere or saved. You also would pay more over the long term if interest rates stayed low for an extended period or fell; though in the latter case, you could refinance.
A personal fit
Choosing between fixed-rate mortgages and adjustable-rate mortgages is really a matter of current rates, your personal investment horizon and the economy. In addition to deciding whether you want to risk a rate hike, you also have to consider how long you plan to own the home, differences in closing costs and whether you will meet the qualifications for each type of loan.
Still uncertain? Use the Bankrate.com ARM or fixed-rate calculator to simplify your decision.