Fixed-Rate vs. Adjustable-Rate: Which Loan is Right For Me?
The home mortgage process usually begins by narrowing down the best home loan for your needs. You probably started your search by learning about the difference between conventional loans and unconventional loans and now you’re in the dilemma of choosing between the two types of Conventional Loans: a fixed-rate mortgage or an adjustable-rate mortgage.
You may be tempted to fall into a fixed-rate, because it’s often viewed as the safest mortgage option for first time home buyers. Before you pick a home loan on an impulse, you should ask yourself: is it really the most appropriate option for my future? Despite how common fixed-rate mortgage loans have become, your situation may benefit more from an adjustable-rate loan (ARM).
The first step to choosing the best mortgage plan for your family is understanding your options. We’ve put together this guide to help you understand the difference between a Fixed-Rate Loan and an ARM Loan.
What is a Fixed-Rate Mortgage?
The name itself can pretty much explain what type of loan this is. A Fixed-Rate Mortgage is mortgage loan with a fixed rate for the term of the loan. This has become a highly coveted and popular choice for homeowners who’d prefer having a steady, consistent monthly payment for an extended period of time.
The Benefits of a Fixed-Rate Mortgage
There are a bunch of benefits to having a fixed-rate mortgage. Here is a list of the most common.
- Your monthly payments will always be the same. This can make it easier for you to plan your budget, seeing that you won’t have to worry about an increase in your payments.
- Your home equity can increase over time. By paying off the principal a little each month, your home equity can increase.
- You have the option to pay off the principal early. Typically, most fixed-rate loans don’t come with prepayment penalties, so you’re free to pay more each billing cycle. This is a great idea for freeing up extra funds in your budget for the future.
- You don’t have to worry about rising interest rates. Unlike ARM’s, the fixed-rate loan is locked-in. This prevents you from having to pay higher interests rate as the market fluctuates.
The Drawbacks of a Fixed-Rate Mortgage
Of course with every decision, there have to be a few drawbacks. When you’re torn between the two types of conventional loans, be aware of these facts about fixed-rate mortgages.
- The interest rate can be higher. If interest rates remain the same or fall with the housing market, your interest rate can be higher than that of an interest-only or ARM loan.
- You pay off the principal at a slower rate than an ARM loan. Payments over the first few years will typically be applied to the interest of your mortgage. This can be especially disadvantageous if you are planning to sell your home and move within 5 to 10 years.
- It’s harder to qualify for fixed-rate loans. Banks may lose money if rates go up, and they want to be sure of who they’re providing, say, a 30-years worth of finances. Due to the higher risk of loss of the banks, the prerequisites for a fixed-rate loan can be numerous, as opposed to an ARM loan.
- You pay higher closing costs. Again, the bank is looking to secure their investment for the duration of the loan. They may lose money if rates go up, and they want to be paid to cover the risk.
Types of Fixed-Rate Mortgages
If you’re at the point where you’ve decided on a fixed-rate mortgage as your home loan choice, you’ll need to decide between the different options available. Here are the most common types of fixed-rate mortgages.
- A five year mortgage maintains the same interest rate for the first five years of the loan. It then is turned into an adjustable-rate mortgage. The initial interest rate will be lower than a 30-year mortgage, but could raise depending upon fluctuations in rates after 5 years. If you are certain you will sell your home within five years, this is the best option for you
- A 15-year fixed rate mortgage can have lower interest rates. If you are able to pay the principal faster than a 30-year loan, you will, as a result, build equity rapidly over time. The drawback of this loan, however, is your payments will likely be higher. This is a good option for those who plan on staying in their home for 15 years, and maintain and steady, reliable income.
- A 30-year mortgage is the most conventional loan. Despite its higher interest rates, the monthly payment is lower (since, of course, the repayment is spread over a 30 year plan). If you intend to stay in your home for the long-run, this is a good loan program for you.
Adjusted-Rate Mortgages (ARM)
What is an Adjustable-Rate Mortgage?
As the name implies, an adjustable-rate mortgage is a home loan with an interest rate that is subject to periodic change. Monthly payments can go up or down based upon the average interest rate in the area you reside after a brief fixed-rate period (which, typically, is 5 years).
The Benefits of an Adjustable-Rate Mortgage
At this point, you’re probably wondering how an ARM loan stands up against a fixed-rate mortgage. To help you in the decision stage, here are a few good points about acquiring an ARM loan.
- Purchasing a larger home for a lower interest rate is possible. The ARM typically features lower rates and payments early into the contract, which can allow people to buy a larger home than a fixed-rate would allow them to buy.
- They’re ideal for short-term homeowners. Because the interest rates in areas rise and follow, a buyer looking at a temporary home option is at low risk of higher payments. If you plan to move before, say, a five-year ARM loan resets, you’re safe from fluctuating interest rates, and will ultimately save money.
- Your interest rate may go down. After the fixed-rate period ends, the interest rate in your area of residence can possibly decrease, which results in your monthly payments lowering.
The Drawbacks of an Adjustable-Rate Mortgage
Before going head first into an ARM loan, you’ll need to understand some of the features that can make or break your decision.
- Interest rates and payments have the potential to rise. If the rates in your area raise, you can expect a higher payment and interest rate. Housing markets often fluctuate, meaning your ARM has the possibility of increasing based on the rate trends in your area.
- Borrowers can end up owing more money than they did at closing. This is a very situational case. Certain ARMs, referred to as “negative amortization loans”, the borrower has the potential to owe money. This is because the payments on the loan is set so low that they only cover part of the interest due. The remainder of the payment is rolled into the principal balance.
Types of ARM Loans
Mortgage Lenders have the ability to organize and structure ARM loans in multiple ways, but they must meet the federal lending laws. It’s best to inquire with your lender on what your options are. To give you an idea of the different types, here are a few common ones:
- 1-year ARM: This loan will be fixed for the first year with annual rate adjustments for the following years.
- A 7/1 ARM: Has a fixed interest rate for 7 years, then adjusts annually for the remaining term.
- A 5/1 ARM: is a fully amortized loan that is fixed for 5 years, then then adjusts annually for the remaining term.
- An Interest Only ARM only requires monthly interest payments, meaning you are not paying off the principal. This provides a lower monthly payment, but causes at balloon payment at the end of your Mortgage term. Like a fully amortized loan, your rate will be fixed for a brief period of time, then adjusted annually.
So, Which Loan Type is Right for Me?
Let’s recap: a fixed-rate loan maintains the same interest rate and payments over an extended period of time. An ARM loan maintains its interest rate for a small period, then adjusts annually. The risk of an ARM as opposed to the consistency of a fixed-rate loan can make the choice seem easy to make, but consider the following:
- Are you staying in your home long-term? If you’re planning to move within a few years, a lower-rate ARM may be right for you. They can be more affordable if you get a reasonable lower monthly payment and rate. The extra leftover cash will allow you to build savings for your future home. You’ll also won’t be exposed to fluctuating rate adjustments if you choose an ARM that suits your plans. Remember: a fixed-rate loan is, ultimately, a long-term commitment.
- How frequently will your ARM adjust, and when will it be made? After the initial fixed-period, your ARM will likely adjust every year on the anniversary of the mortgage. The new rate will be set days beforehand, based on the index your lender provides, but some can adjust monthly. If the monthly fluctuation is too much for you to budget around, we recommend a fixed-rate mortgage.
- What is the interest rate like in your area? When the local interest rates are high, it make the most sense to choose an ARM loan, because they allow lower initial rates while allowing borrowers to become homeowners. Fixed-rate mortgages make the most sense when you plan on buying long-term in your area and want to have your interest rates stay low.
- If interest rates are high, could you still afford your monthly payment? It’s always a good idea to give yourself leeway when paying bills: especially when dealing with home payments. When looking into an ARM, be sure to calculate how much of a monthly payment you can reasonably afford if your rates were to rise over time. If you’re uncertain you can reasonably pay your monthly payments with a higher interest rate, it might be worth looking into a Fixed-Rate Mortgage Loan.
Once you’ve determined the answer to those four questions, you can start to weigh your options. A generally good rule of thumb is to consider a Fixed-Rate Loan for a long-term contract, and an Adjustable-Rate Mortgage for a short-term contract.
The Right Loan is Only a Call Away
Still uncertain of which loan is right for you? Feel free to give Prysma a call today, and we’ll get you in touch with a loan originator. They’ll walk you through each option step by step, and help you determine the most appropriate loan option for your home. Give us a call today at 888-743-9985