When it comes to buying or refinancing a house, no two situations are exactly the same. That’s why there are a variety of mortgage options available—including fixed rates, adjustable rates or even a combination of the two.
The right choice for you can depend on many factors, including the length of time you plan on owning your home. For instance, if you expect to own for 10 years or less or if interest rates are high when you are looking to buy, a 10/1 adjustable-rate mortgage, or ARM, may be a better choice for you than the more popular 30-year-fixed mortgage.
How do ARMs and fixed-rate mortgages differ?
As the name implies, a fixed-rate mortgage has the same interest rate from the time you take out the loan until you pay it off. With an ARM, however, the interest rate may go up or down after a set period of time. Usually ARMs are expressed in two numbers, with the first number identifying the period the loan’s interest rate is fixed and the second number indicating the annual frequency the interest rate is adjusted following the initial fixed period.
For example, 10/1 ARM, has a set rate for 10 years, after which the rate adjusts annually based on a benchmark interest rate chosen by the lender, such as LIBOR. If the benchmark rate declines, your monthly payment could go down, depending on the terms of your mortgage. Some ARMs also set caps on how high or low your interest rate can go.
Comparing a 10/1 ARM with a 30-year fixed-rate mortgage
At first glance, it’s easy to see why the 30-year fixed-rate mortgage is a consumer favorite. By locking in your rate, your monthly principal and interest rate payments stay exactly the same, giving you no surprises about your loan cost over time and making it easier to budget for the future.
What’s more, in the low-rate environment since 2010, locking in a fixed rate can be a smart move. Currently, the difference between the rates on the 10/1 and the 30-year is only about 0.125 percent to 0.375 percent, making the long-term guaranteed rate relatively attractive.
But as rates creep higher, you might get a lower rate with a 10/1 ARM than you would with a 30-year fixed-rate mortgage, potentially saving thousands of dollars over the life of the loan. For instance, let’s say the spread between the two rates is 0.5 percent and you are choosing between a $200,000, 30-year fixed at 5 percent or a 10/1 ARM at 4.5 percent. You’d pay about $1,074 a month for the fixed-rate loan but only $1,013 for the ARM. That may not sound like huge savings, but over 10 years, you’d spend $7,320 less in monthly mortgage payments with the ARM.
How long do you plan to stay in your house?
Before choosing a mortgage product, it’s critical to consider how long you might remain in your house. For instance, buyers aged 36 years and younger typically expect to stay in a house for about 10 years compared to 20 years for buyers 52 to 61 years, according to the National Association of Realtors.
If you anticipate moving before your initial, 10-year interest rate expires, you will reap savings at no added risk by taking out a 10/1 ARM. But if there’s a chance you might stay in your house for more than 10 years, you run the risk that interest rates could adjust higher in the future, thus making an ARM more expensive in the long run.