Congratulations! You have saved up enough money to purchase a home — now it is time to look at mortgage options. Is a fixed-rate mortgage or an adjustable-rate mortgage (ARM) better for your situation?
It depends on your finances, your goals, and the overall market circumstances. Generally, ARMs provide lower interest rates than fixed loans in the early years, but contain more long-term risk.
A fixed rate loan is simple to analyze. You pay a fixed rate over the entire life of the loan and have predictable monthly payments regardless of market rates. Therefore, a fixed-rate loan is more attractive when current interest rates are low and/or likely to rise in the future (like now).
While a fixed-rate loan is usually better during times of low interest rates, you may want to consider an ARM in these cases:
- If you plan to sell or move within a few years.
- If you plan to pay off the mortgage within a few years (and can do so without prepayment penalty).
- If you intend to refinance at a later date (and can do so without penalty). Doing this assumes favorable interest rates will be available, so consider the risk.
- You are in a financial position that is solid in the future but currently weak, and you need lower initial payments.
Interest rates on ARMs change on a periodic basis, based on a fluctuating market index value like the London Interbank Offered Rate (LIBOR) and a constant margin. Combine the two to get the fully indexed rate (the rate you will pay for that period). For example, if the current index is 4% and your margin is 2%, your fully indexed rate is 6%.
ARMs are available in several varieties:
- Regular ARM: As described above, with a variable interest rate over the length of the loan.
- Hybrid ARM: Starts as a fixed-rate loan (typically a 3- to 5-year term), then switches to an ARM over the remainder of the loan. This is especially good if you plan to move or sell early, and can lock in a lower interest rate without penalty for early sale or refinancing.
- Interest-Only ARM: An ARM with payments lowered so that they only cover interest for several years, paying none of the principal. In this case, you will have larger future payments and no early equity. You will need to have a secure income later in the loan.
- Payment Option ARM: You have monthly options for traditional, interest-only, or limited-payment methods. Concerns are similar to an interest-only ARM, and it is easy to slip into negative amortization (unpaid interest added to principal, making your overall debt higher while still making payments on time).
- Convertible ARM: This contains options allowing for a conversion to a fixed-rate under certain conditions.
Other features of an ARM to check are:
- The cap on the interest rate increase, either lifetime or periodic (periodic caps change at certain points over time).
- Any penalties for early payment or refinancing.
- Potential balloon payments at the end of the loan.
- The recalculation period or recasting of the loan (typically 5 years). Payments may be recalculated as if it were a new loan, and the payment caps may not apply.
In short, fixed-rate mortgages provide stability at higher cost; ARMs can save money but require fiscal diligence to avoid losing money.
CAUTION: Whether you get an ARM or fixed-rate loan, do not let a low interest rate, discount points or any other feature fool you into buying a more expensive house than you can afford. Assess your ability to repay the loan realistically. Make conservative assumptions on income amount and stability, potential future debts, and future changes in the interest rate. Many Americans who did not heed this advice lost their homes during the economic downturn. You can check your credit score and read your credit report for free within minutes using MoneyTips' Credit Manager.