ExecutiveChronicles | Fixed Rate vs. Adjustable Rate | If you’re in the market to buy a new home, then you know there are a lot of exciting decisions to make. Once your offer has been accepted, for instance, you now have to decide on your loan term and type.
One of the decisions you’ll likely face when it comes to closing on your new home purchase is whether you want a fixed rate vs. adjustable rate mortgage (ARM). So, what’s the difference, and when is the right time for borrowers to choose an adjustable-rate mortgage? We’ll share what you need to know.
Fixed Rate vs. Adjustable Rate
With a fixed rate mortgage, you have a fixed interest rate that will remain the same over the life of the loan. The rate is based on current market conditions. With an adjustable-rate mortgage, the rate fluctuates as market conditions change over the life of the loan. One benefit of borrowers choosing an adjustable rate mortgage is that ARMs typically offer lower interest rates at the start of the loan term.
So how exactly does an ARM work? When you close on an ARM, you have a fixed interest rate for a set period. How long that locked-in interest rate lasts depends on your lender. Some locked-in interest rates last only 30 days, while others can last up to 5 years.
Once the initial interest rate expires, the interest rate and payments adjust periodically over the remainder of the loan term. The rate at which it adjusts varies based on the particular loan, but it will typically adjust monthly, quarterly, annually, or once every three or five years.
To get an idea of how much your loan will cost overall, ask your lender for the annual percentage rate (APR) on the loan. You should also inquire about interest-rate and payment caps. For more information and examples of how ARMs work, the Federal Reserve Board has a consumer handbook with all the details you need to know before deciding on an ARM.
When Is the Right Time to Opt for an Adjustable-Rate Mortgage?
Borrowers choosing an adjustable-rate mortgage do so for a number of reasons. For instance, if you’re buying an investment property that you plan to sell in a few years, it may be to your advantage to opt for an ARM.
Likewise, if you’re planning on moving soon and intend to sell your home in the not-so-distant future, an ARM could be a good option. This is especially true if you’re planning to relocate before the variable interest rate kicks in.
You may also opt for an ARM if you expect mortgage rates to drop over the life of the loan. Since interest rates are based on market conditions, if interest rates are especially high at the time you’re looking to close, it may be more beneficial for you to opt for an ARM over a fixed-rate mortgage. When interest rates decrease, your monthly payments on an ARM may also decrease. With a fixed-rate mortgage, on the other hand, your rate is locked in for the life of the loan regardless of any change in market conditions.
If you expect to come into some money in the near future that would allow you to pay off your mortgage, you may also benefit from an ARM. Let’s say you’re expecting a windfall within the next few years. An ARM may be advantageous because you are likely to have a lower interest rate until you are able to pay off the mortgage in full.
This type of ARM is a hybrid between a fixed-rate and a variable-rate mortgage. They may also be labeled as 3/1 ARMs, 5/1 ARMs, or the like. The first number represents the length of time the interest rate will remain at a fixed rate, and the second number represents how often the rate will adjust after the initial rate expires. With a 3/1 ARM and 5/1 ARM, for instance, the rate would be fixed for 3 and 5 years, respectively. After that, the interest rate switches to a variable rate.
You can think of an interest-only ARM as similar to a home equity line of credit. With this ARM type, you pay only the interest on the loan for a set period of time. Once that time is up, you start paying back the principal plus interest. The interest rate may adjust even during the initial period in which you are making interest-only payments.
With this type of ARM, you can choose from a variety of monthly payment options. For instance, you can make an interest-only payment, a principal-plus-interest payment, or a minimum payment (similar to a credit card). Be careful with this type of ARM, though. If making only the minimum payment or an interest-only payment, the principal amount that you owe on the loan could grow.
What Borrowers Choosing an Adjustable-Rate Mortgage Should Know
There are facts to keep in mind when choosing an ARM. For starters, do your research by looking over the consumer handbook. Prepare a list of questions for your lender so you know what to expect, especially when it comes to interest-rate and payment caps. Make sure to do the math and calculate whether you can afford the maximum payment.
Also, ask about prepayment penalties for paying off the mortgage early. If interest rates rise, you may decide that you prefer to do a refinance for a fixed-rate mortgage. So it’s a good idea to find out whether you will incur any fees for paying off the mortgage early.
If you’re based in Washington State and a borrower choosing an adjustable-rate mortgage, contact Solarity Credit Union. Whether you’re upsizing, downsizing, or investing, they can walk you through your options and help you find the right loan for you.
ExecutiveChronicles | Fixed Rate vs. Adjustable Rate