Fixed-Rate Versus Adjustable-Rate Mortgages: Pros and Cons
As you look for a home, whether it's your first or your fifth, you'll need to decide whether you want to get a fixed-rate or an adjustable-rate mortgage. What's the difference? With fixed-rate mortgages, monthly payments remain the same for the life of the loan, no matter how long it runs. With an adjustable-rate mortgage (ARM), monthly payments remain the same for a set period, then may change thereafter.
While predetermined rates with a fixed-rate mortgage mean that you always know what your payment is, an ARM tends to have a lower initial interest rate and the potential for monthly payments to drop. Of course, depending on the market, your payments also could become higher over time.
There are some interesting ARMs out there: In a 5/1 ARM, the rate is fixed for five years and then changes once annually. Similarly, there are 3/1, 7/1 and 10/1 ARMs, meaning that your rate could be fixed for three, seven or 10 years before adjustments.
Many homeowners like the stability of a fixed rate because it makes it easier to budget:. With a fixed-rate mortgage, your monthly payments are predetermined. But if you want to take a chance at saving money, you'll be able to do so with an ARM's low initial rate. Do you want to pay more in the interest of stability? Are you willing to take a chance that payments will rise if interest rates do?
Also consider lifestyle choices: A fixed-rate mortgage works if you're established in your career and expect to settle into your new house for years. If you expect to move in a few years, then perhaps you can opt for an ARM and save money during the initial fixed-rate period before you sell and move on. Of course, homeowners with fixed-rate mortgages can always refinance to take advantage of falling rates if they don't mind paying out more closing costs. It may be worth it.
Some ARMs set a cap on how high your interest rate can go, and some limit how low your rate can go. In considering the pros and cons of ARMs, find out:
- How high your interest rate and monthly payments can go with each adjustment.
- How frequently your interest rate will adjust.
- How soon your payment could go up.
- Whether there is a cap on how high your interest rate could go.
- Whether there is a limit on how low your interest rate could go.
The main advantage of a fixed-rate loan is that you're protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise. Fixed rates are easy to understand and vary little from lender to lender. The downside is that if interest rates are high, qualifying for a loan is more difficult because the payments are less affordable. Thirty-year mortgages tend to offer the lowest monthly payment. The trade-off for the low payment is a significantly higher overall cost because the extra decade or more in the term is devoted primarily to paying interest. Shorter-term mortgages cost significantly less.
Another advantage of an ARM: Its initial low payment may enable you to qualify for a larger loan, and in an environment with a falling interest rate, that allows you to enjoy lower rates without needing to refinance. Consider personal factors too, and balance them with the economic realities of an ever-changing marketplace. Your finances often experience periods of advance and decline; interest rates rise and fall, and the economy itself waxes and wanes.
Choose carefully to avoid costly mistakes.