March 25, 2024

Understanding Mortgage Options: Fixed-Rate vs. Adjustable-Rate Mortgages

When you’re shopping for a mortgage, you may be overwhelmed by the number of options. Different lenders offer different rates, terms, and costs, making it hard to decide, but it doesn’t have to be that complicated! The first step is to decide between fixed-rate or adjustable. There are many different terms, points and rates associated with each, but narrowing your search to a category can simplify the process.

As an overview, fixed-rate mortgages are the traditional choice. You agree with the lender on a term (how long you will pay the mortgage) and an interest rate. That interest rate stays the same throughout the term of the mortgage.

Adjustable-Rate Mortgages (ARMs) are a newer offering. These mortgages have a fixed interest rate for a set period, then the rate changes based on economic indicators. For example, an “ARM 5/1” means the rate is fixed for the first five years, then it changes every year after that.

So, which option is right for you? The answer really depends on several factors.

How long do you plan to own your home?

When you’re shopping around for mortgages, you will notice that Adjustable-Rate Mortgages (ARMs) often have lower interest rates, sometimes by as much as 0.50%. That means on a $200,000 mortgage, you could save as much as $70 every month! The reason for these lower initial rates is that the lender is taking on less risk. With a traditional mortgage, if interest rates go up, the lender ends up with a smaller return. But with an ARM, you’re agreeing to pay more if the lending market demands it.

This consideration becomes less important if you don’t plan on owning your home in five years. For example, if your job involves moving around a lot, taking advantage of the monthly savings from an ARM, and putting it into your 401(k) is a good move. Similarly, if you’re looking to buy a house, fix it up, and then sell it for a profit, going with an ARM can help cut your costs while you’re living there.

However, there are risks involved with ARMs even if you’re planning to sell your house. If demand drops in your neighborhood, you may have trouble finding a buyer. In that case, you could be stuck with the loan and face increasing interest rates. Even if you do find a buyer but can’t sell the house for the price you paid, the gap between the sale price and what you owe will keep affecting your monthly finances until you get it paid off.

On the other hand, if you’re in your house for the long haul, the initial savings from an ARM might not matter much once the adjustment period kicks in.

How much can you afford to put down?

An ARM can be easier to qualify for and provides you with an interest rate that you might not get without a 20% down payment. If you don’t have enough cash upfront to make a large down payment, an ARM might give you some time to build equity. Refinancing your mortgage after the initial period is over can put you in a better position. You can use the equity you have in your home, plus whatever you’ve saved during that time, to put more money down and secure a better fixed-rate mortgage.

Of course, this strategy is not without risk either. If the value of your home decreases, you may have a difficult time refinancing for the balance of the loan after the initial term. This could leave you stuck paying the higher interest rates of the ARM. If you can’t make the payments, you face losing your home, regardless of the equity you’ve established.

If you’ve got the cash for a 20% down payment or are buying in a fluctuating housing market, a fixed-rate mortgage offers stability and favorable rate that you can rely on. Your mortgage payment stays the same from month-to-month and there’s no uncertainty about what global economies do in the interim.

What’s your risk tolerance?

At the core of the choice between fixed-rate and adjustable-rate mortgages lies a simple but effective shortcut. Fixed-rate mortgages are the safer, more conservative option, while adjustable-rate mortgages present a riskier alternative, but offer the possibility of savings.

If you have the flexibility in your budget to accommodate a potentially fluctuating mortgage payment and feel secure in your employment, savings, and other financial priorities, an ARM does offer the potential to lower your monthly payment. If you’re confident that the value of your home will increase faster than interest rates, an ARM might be a wise investment.

If you prefer the security of a fixed-rate mortgage, there are compelling reasons to choose that path. If you’ve found the perfect home to raise a family in, the stability of a fixed-rate mortgage may be desirable. Additionally, if you’re trying to find the simplest path to homeownership, the straightforward nature of a fixed-rate mortgage can be very appealing. It might be easier to be financially aggressive in other aspects of your life, and not put the place where you live at risk.

Related Content: Utilizing Home Equity: What You Need to Know About the Home Equity Line of Credit

Equal Housing Lender

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