ARM Loans vs Fixed-Rate Mortgage: Which is Right for You?
Mortgages come in many forms. When you start looking at all the different types of loans, it can be fairly overwhelming. You’ll find 30-year, jumbo, conventional, VA, balloon, USDA, and more; navigating it all can seem impossible!
However, you can simplify the process by first choosing between an adjustable-rate or fixed-rate mortgage. Each one has their advantages and drawbacks, so let’s look closer at each type so you can make the right decision.
Understanding ARM Loans
What is an ARM Loan?
The main factor with adjustable-rate mortgages is that the interest rate changes throughout the life of the loan, meaning the monthly payments can also go up or down. However, most ARM loans will have a fixed interest rate for a specific time period at the beginning of the mortgage. During this initial locked-rate period, the monthly payments will stay the same, providing some stability and predictability to the loan.
After the initial period with a locked-in rate, the interest can begin to change. However, the interest rate does not change randomly; it moves up or down alongside index rates, which is the rate set my market forces and established by a neutral party. There are many different indexes, and the one used on your loan will be defined in the paperwork. Specific indexes that can be used in ARM loans include the U.S. Treasury Bill, the London Interbank Offered Rate, or the Constant Maturity Treasury, among others.
Adjustable-rate mortages also include a “margin.” This is the agreed amount that will be added to the index rate. For example, you may have an index rate of 2% and a margin of 2%. In this case, the total interest would be 4%. Next year, if the index rate goes up to 3%, the interest would be 5%. (In most cases the margin will not change, only the index rate.)
It’s important to understand that an ARM loan is capped at a certain percentage and monthly total, so it can’t go up to extremely high rates pr payments. This helps protect you from soaring year-to-year increases. The caps on an ARM will come in several forms. First, there is a cap on how much the interest rate can change from year to year, so it won’t bump up significantly from one year to the next. There is also a lifetime limit on how much the interest rate can rise. Finally, there is a payment cap that limits the amount that the monthly payment can rise. All of these protections make ARM loans less risky to home buyers.
Advantages of an ARM Loan
One of the top advantages of an ARM loan is that the initial interest rate is generally lower than fixed-rate mortgages. In many cases, the lender or bank will essentially reward you with a lower initial interest rate because you are taking a risk that rates might go up. This means that the payments for the initial period are less. There is also the chance that interest rates could go down, which means your monthly payments would go down as well. While this is not guaranteed, it is a possibility.
Disadvantages of an ARM Loan
There are, of course, disadvantages to an ARM loan. Most significantly, there is a chance that the rates will go up and you will eventually have to make larger payments. Interest rates are unpredictable, and even the best economist in the world can’t perfectly predict what interest rates will be in 10, 15, or 30 years. This unpredictability means you will have a difficult time estimating your future payments.
When is an ARM Loan the Right Choice?
The top reason to choose an ARM loan is if you plan on staying in the home for only a short period. Because ARM payments are generally lower during the initial five or ten years, it is possible to use these loans to purchase a house at a lower rate, then sell the home and avoid the higher future costs. If you consider the house a starter home, or if you need the savings from the initial period to accomplish other financial goals, then it may be a good choice. Also, if you plan on making extra payments towards the loan during the low-interest period, you can realize significant savings. (If using an ARM loan, be sure to double check for any prepayment penalties.)
Understanding Fixed-Rate Loans
What is a Fixed-Rate Loan
As the name suggests, fixed-rate mortgages have an interest rate that is locked in for the life of the loan. The interest rate at the time of purchase is the interest rate for the life of the loan. These rates are decided by forces that aren’t controlled by the lender, including the secondary markets where mortgages are bought and sold.
Fixed-rate mortgages are the most common type of home loan. Because the interest rate remains the same, the monthly payment is also consistent. While property taxes, insurance, HOA fees, and other costs can change through the years, the exact amount you pay to the bank from month to month is consistent.
When is a Fixed-Rate Loan the Right Choice?
Most people who intend to stay in their home for five years or more will benefit from a fixed-rate mortgage. Over the life of the loan, the interest rate and total payments are more consistent, and you will generally find that fixed-rate mortgages bring greater long-term cost savings.
Even with built-in protections for adjustable-rate loans, there is more reliability and stability with fixed-rate mortgages. You are not merely protected from changes in interest rates, you are completely immune to changes in the indexes. While lower interest rates can bring smaller payments for ARM loans, it’s always possible to refinance your fixed-rate mortgage to take advantage of better terms. This takes time and there are costs involved, but this somewhat counteracts one of the main benefits of adjustable-rate mortgages.
Common-Sense Underwriting for Fixed-Rate and ARM Loans
Whether you have decided on an ARM loan or a fixed-rate mortgage, the team as San Diego Purchase Loans will use common-sense underwriting to get you approved.
Contact us today and put our experience and dedication to work for you!