Buying a home comes with an incredible amount of decisions to make, whether it’s deciding on a neighborhood, finding just the right house to fit your lifestyle or determining what loan program works with your financial goals. Once you’ve narrowed down a specific mortgage program, you will have one final decision to make: is a fixed rate or adjustable rate for you?
Mortgage 101: Fixed Rate vs Adjustable Rate
A fixed rate mortgage has a consistent rate, and monthly mortgage payment. With a fixed rate mortgage, your monthly mortgage and interest payments will remain the same, although other costs such as property taxes or mortgage insurance can change.
An adjustable rate mortgage has an initial interest rate period. After this introductory period is over, an adjustable rate mortgage can adjust up or down for the remainder of the loan term in accordance with the specificed index and margin.
Fixed Rate Loans: Steady and Reliable
It should come as little surprise that the consistent rate and reliable mortgage payments of a fixed rate loan makes it the most popular choice for first time buyers. Knowing that your rate and payment will stay the same for the next 15 or 30 years makes financial planning and household budgeting simple and easy.
However, if you only plan to stay in your home for 5 to 10 years, a fixed rate may not make sense for your financial goals. This is because a fixed loan comes with a rate that is often higher compared to an adjustable.
While various fixed rate options are the choice for many borrowers, there is another option. For buyers who want to pay down their principal balance rapidly, and pay off their home quickly, a shorter term mortgage can help them do just that. With a shorter term, you can own your home free and clear in quicker than compared to a longer term mortgage. That means a potential savings of thousands, or even tens of thousands, of dollars in interest payments. A shorter loan term option is usually available at a lower interest rate than a longer term, although the total monthly payment will be higher.
Who it’s for:
- Borrowers who want a simple, easy to understand loan.
- Borrowers who want the stability of consistent rates and payments.
Adjustable Rate: a Powerful Tool for Short-term Savings
The interest rates of an adjustable rate mortgage (ARM) can offer a compelling alternative mortgage option for certain borrowers. For the initial interest rate period a borrower can save hundreds of dollars each month compared to a fixed rate loan, which may add up to tens of thousands of dollars during that period. For some borrowers, that means more cash for investments. For other borrowers, an ARM is a tool that allows them to qualify for more house compared to a fixed rate loan. They believe the extra square footage and hardwood floors are worth the risk that comes with an adjustable mortgage. For others, these loans make sense if you know that you only plan to stay in the home for a short period of time.
At the end of the initial fixed period, an ARM will adjust either up or down, depending on the financial index that it’s tied to. There is a chance that the interest rates will have dropped, and you will get the benefits of a lower rate without having to refinance. On the other hand, there is a very real risk that the interest rates will be higher. That means a higher rate and higher monthly mortgage payment.
Once you enter the adjustable period of your ARM loan, your interest rate can adjust every year. While there are caps (limits) to how high your rate can adjust initially, each subsequent year, and even a lifetime limit… you could still be facing rates and payments double of what you started with.
Not knowing where the rates will go, or what your housing costs could be next year, can make it difficult to do any kind of long-term financial planning.
The attractive initial rates of an ARM can make it a powerful tool for buyers who fully understand the pros and cons of this type of loan, and the details of a more complicated loan program.
Who it’s for:
- Borrowers who want to free up cash to reach short-term financial goals.
- Borrowers who want to qualify for larger mortgage amounts to afford more home.
- Borrowers with short-term plans to sell and move up to a larger home, or plans to eventually relocate.
When to Refinance
As a first time homebuyer, refinancing probably isn’t at the top of your list of things to do right at this moment. (A list that is most likely more focused on where to find boxes and packing materials, and what color paint is best for the interior of your new home.) The option to refinance could be the deciding factor between a fixed and adjustable rate loan.
The average time for a homeowner to refinance is 5 to 7 years, which just happens to fall right in the middle of the introduction period of most adjustable mortgages. That means you could very well refinance out of an ARM into a fixed rate mortgage, or even back into another ARM to take advantage of another short-term, low interest rate period.
If you would prefer to choose a loan that doesn’t require you to consider a refinance quite so soon, a fixed rate loan may be for you.
There are definite benefits to both a fixed rate and adjustable rate mortgage. The rates offered to you by a lender, your financial goals, how long you intend to stay in your home, and your tolerance for financial risk will be the biggest deciding factors in choosing between a fixed and adjustable rate mortgage. If you still aren’t clear about which option is for you, don’t panic. That’s why you have an experienced American Pacific Mortgage loan advisor by your side, so you can understand all of your options and select the loan program that may be a good choice for you.