The home buying process can get sticky fast. There's finding the right home, negotiating with the seller, and trying to figure out if you'll close on time.
But there's one aspect to the process that causes a lot of hopeful homeowners to pause: how to fund their home purchase. If you're like them, know this: There are two common types of mortgages—ARM vs. fixed-rate mortgages. How do you decide which is best for you? Let's find out.
Fixed-rate mortgages are popular because they have an immoveable interest rate. This is reassuring to buyers who don't want to see their payments go up or down every month.
The most common type of fixed-rate mortgage is the 30-year fixed rate mortgage. A fixed-rate mortgage establishes monthly payments based on many factors like the life of the loan (in this case, a fixed period of 30 years), principal and interest, and your loan amount.
There are no rate adjustments with fixed-rate mortgages and this is one of the benefits of this type of lending. This means that despite variables in the economy, your rates will remain fixed for the entirety of your loan term. The Great Recession, for example, had many homeowners with fixed-rate mortgages breathing sighs of relief because they did not succumb to interest rate increases due to the struggling economy. Those without fixed rates suffered.
Another benefit is that a fixed-rate mortgage is easier to budget for in the long term. That's because borrowers know what their payments will be each month. Lenders of fixed-rate mortgages give their clients an amortization sheet breaking the payments down over 30 years. This helps borrowers know when they'll pay off their loan and even helps them see how much they would save by paying just a bit more each month.
Drawbacks of Fixed-Rate Mortgages
A downfall of fixed-rate mortgages is that they often need refinancing to lower your interest rate and are not as customizable as adjustable-rate mortgages.
Adjustable-Rate Mortgages (ARM)
Adjustable-rate mortgages, or ARMs, differ from fixed-rate mortgages in that the interest rate is not fixed and can go up or down depending on a few factors.
One of these factors is the introductory period. This is a period is usually at the beginning of the loan term. The initial rates of ARMs are typically lower to begin with.
Lenders offer an alternative rate (aka teaser rate) as well. They offer this introductory interest rate to entice a borrower to choose a certain mortgage program like a 5/1 ARM, for example.
A 5/1 ARM is a type of adjustable-rate mortgage program that offers a fixed interest rate for a certain amount of years (for a 5/1 ARM, it is five years) and the interest rate adjusts annually.
When considering any type of ARM, it’s crucial to ask about the program’s lifetime cap rate, as this is the most they'll raise your interest.
Advantages of Adjustable Rate Mortgages
One of the major advantages of adjustable-rate mortgages is that the initial rates are usually lower than fixed-term rates. This means that a borrower is able to afford a larger home because their payments start out lower.
ARMs also do not need re-financing and offer cheaper mortgage rates for borrowers. Especially if you plan on moving before you've paid for the house in full.
Disadvantages of Adjustable Rate Mortgages
While ARMs do offer an array of advantages, they are not without disadvantages.
One of the downfalls of ARMs is that rates (and, thus, payments) can significantly increase over the loan’s lifespan. Although there is a cap rate, you can expect your interest to rise and fall many times throughout the life of the loan.
Another disadvantage is that ARMs are more difficult to understand than fixed-rate loans. Because of this, lenders have more flexibility and borrowers who don’t understand the ins and outs of ARMS may find themselves under the negative influence of greedy lenders.
ARM vs. Fixed-Rate Mortgages: Which is best?
ARMs and fixed-rate mortgages both have advantages and disadvantages and the decision comes down to the borrower’s needs.
A big determining factor in which program to decide on is how long you plan on living in the home. A lower-rate ARM would make more sense if you are planning on moving in a few years.
Further, ARMs differ on when they adjust and by how much. Consider whether you are comfortable with and can afford monthly payments that change. If you cannot afford it, an ARM may not be for you. According to experts, if the interest rates are low, a fixed-rate mortgage is a better deal.
Sometimes, ARMs can save borrowers in the long run. When calculating what you can and cannot afford, be sure to consider your personal finance goals as well as your credit scores. Your credit will play a large role in your interest rates. Additionally, your financial goals matter. If you are looking to save a certain amount of money over the course of a certain amount of years, factor that into your decision.
As is the case with loans of any kind, we encourage you to do diligent research and seek out second opinions. Be sure to get a second opinion within fourteen days of your initial inquiry to ensure that the credit inquiry does not affect your credit score. If the inquiry happens within this timeframe, it will not count as an extra credit inquiry.