If you are planning to buy a home, one of the most important decisions you will have to make is choosing between a fixed-rate mortgage and an adjustable-rate mortgage (ARM). A fixed-rate mortgage has an interest rate that stays the same for the entire loan term, while an ARM has an interest rate that can change periodically after an initial fixed-rate period. Both types of mortgages have their advantages and disadvantages, depending on your financial situation and goals.
In this blog post, we will cover the following topics:
- How do fixed-rate mortgages and ARMs work and what are their main features?
- What are the benefits and drawbacks of fixed-rate mortgages and ARMs?
- How to compare and choose the best mortgage option for your situation?
- How to save money and avoid risks when getting a fixed-rate mortgage or an ARM?
By the end of this post, you will have a better understanding of how fixed-rate mortgages and ARMs work and how to use them wisely and responsibly. You will also learn some tips and tricks to save money and avoid unnecessary fees and charges. You will also discover some alternatives to fixed-rate mortgages and ARMs that may be more suitable for your financial goals.
How do fixed-rate mortgages and ARMs work and what are their main features?
A fixed-rate mortgage is a type of home loan that has an interest rate that remains unchanged throughout the loan term, which is usually 15 or 30 years. This means that your monthly payment of principal and interest will stay the same for the entire loan term, regardless of the market conditions. However, your total monthly payment may vary slightly due to changes in your property taxes and homeowners insurance, which are typically included in your mortgage payment.
An ARM is a type of home loan that has an interest rate that can change over time, depending on the market conditions. Unlike a fixed-rate mortgage, which has a constant interest rate for the entire loan term, an ARM has a lower initial rate that is fixed for a certain period, usually between one and 10 years. After that, the rate can adjust up or down, depending on an index and a margin, at regular intervals, usually once a year.
The index is a benchmark interest rate that reflects the general market conditions, such as the prime rate, the LIBOR, or the Treasury rate. The margin is a fixed percentage that is added to the index to determine the actual interest rate of the ARM. The margin is set by the lender and does not change over the life of the loan.
The interest rate of an ARM is usually expressed as the index plus the margin, or the fully indexed rate. For example, if the index is 3% and the margin is 2%, the fully indexed rate is 5%. However, the fully indexed rate is not the actual rate that you pay on your ARM. The actual rate is usually lower than the fully indexed rate, especially at the beginning of the loan term, because of the initial rate or the teaser rate.
The initial rate or the teaser rate is a discounted rate that is offered by the lender for a certain period, usually between one and 10 years. The initial rate is usually lower than the fully indexed rate, which makes the monthly payments more affordable and attractive for the borrower. However, the initial rate is not guaranteed for the entire loan term, and it can change after the initial period expires.
The frequency and the amount of the rate change depend on the adjustment period and the rate caps of the ARM. The adjustment period is the time between the rate changes, usually once a year, but it can also be monthly, quarterly, or semiannually. The rate caps are the limits on how much the rate can change at each adjustment and over the life of the loan. For example, a 2/2/5 cap means that the rate can change by up to 2% at each adjustment, by up to 2% in the first year, and by up to 5% over the life of the loan.
There are different types of ARMs that have different features and terms. Some of the most common types of ARMs are:
- Hybrid ARMs: These are ARMs that have a fixed-rate period followed by an adjustable-rate period. The fixed-rate period can range from one to 10 years, and the adjustable-rate period can range from 15 to 30 years. The most popular hybrid ARMs are the 5/1 ARM, the 7/1 ARM, and the 10/1 ARM, which have a fixed-rate period of five, seven, and 10 years, respectively, followed by a one-year adjustable-rate period.
- Interest-only ARMs: These are ARMs that allow you to pay only the interest on the loan for a certain period, usually between three and 10 years. After that, you have to pay both the principal and the interest, which can increase your monthly payments significantly. Interest-only ARMs can be hybrid or non-hybrid, depending on whether they have a fixed-rate or an adjustable-rate period.
- Payment-option ARMs: These are ARMs that give you the option to choose from different payment amounts each month, such as a minimum payment, an interest-only payment, or a fully amortizing payment. However, the minimum payment is usually lower than the interest due, which means that the unpaid interest is added to the principal, resulting in negative amortization. Payment-option ARMs can also have a recast period, which is the time when the loan is recalculated based on the current interest rate and the remaining loan balance, which can increase your monthly payments substantially.
What are the benefits and drawbacks of fixed-rate mortgages and ARMs?
Fixed-rate mortgages and ARMs have their advantages and disadvantages, depending on your financial situation and goals. Here are some of the pros and cons of fixed-rate mortgages and ARMs:
Pros of fixed-rate mortgages:
- Predictability and stability: A fixed-rate mortgage offers predictability and stability, as your interest rate and monthly payment will stay the same for the entire loan term, regardless of the market conditions. This can make budgeting and planning easier, as you know exactly how much you have to pay each month and how long it will take to pay off your loan.
- Protection from rising interest rates: A fixed-rate mortgage also protects you from rising interest rates, as your interest rate will not change even if the market rates go up. This can save you money and avoid payment shocks, as you will pay the same amount of interest over the life of the loan.
- Simplicity and transparency: A fixed-rate mortgage is also simple and transparent, as you do not have to worry about complex features and terms, such as the index, the margin, the adjustment period, and the rate caps. You also do not have to monitor the market trends and the index movements, as they will not affect your interest rate and payment.
Cons of fixed-rate mortgages:
- Higher initial rate and payment: A fixed-rate mortgage may have a higher initial rate and payment than an ARM, especially when the market rates are low. This can make it harder for you to qualify for a loan or afford a larger or more expensive home. This can also cost you more money in interest over the life of the loan, if the market rates do not rise significantly or at all.
- No benefit from falling interest rates: A fixed-rate mortgage also does not benefit you from falling interest rates, as your interest rate will not change even if the market rates go down. This means that you will pay more interest than you would with an ARM, unless you refinance your loan, which will entail closing costs and fees.
- Less options and flexibility: A fixed-rate mortgage also offers less options and flexibility than an ARM, as you have to choose from a limited number of terms and features. You also have less control over your interest rate and payment, as they are determined by the lender and the market at the time of your application.
Pros of ARMs:
- Lower initial rate and payment: An ARM can offer a lower initial rate and payment than a fixed-rate mortgage, which can help you save money and afford a larger or more expensive home. This can be especially beneficial if you plan to move or refinance before the rate adjusts, or if you expect your income to increase in the future.
- Rate adjustment can be favorable: An ARM can also have a rate adjustment that is favorable for you, depending on the market conditions. If the index goes down, your interest rate and payment can also go down, which can help you save money and pay off your loan faster. However, this is not guaranteed, and you should be prepared for the opposite scenario as well.
- More options and flexibility: An ARM can also offer more options and flexibility than a fixed-rate mortgage, as you can choose from different types, terms, and features of ARMs. You can also customize your ARM to suit your needs and preferences, such as the length of the fixed-rate period, the frequency and the amount of the rate change, and the payment options.
Cons of ARMs:
- Higher interest rate and payment: An ARM can also have a higher interest rate and payment than a fixed-rate mortgage, especially after the initial period expires and the rate adjusts. This can increase your monthly expenses and reduce your cash flow. This can also make it harder for you to budget and plan for the future, as you may not know how much your payment will be each month.
- Payment shock and negative amortization: An ARM can also cause payment shock and negative amortization, which are two of the most common pitfalls of ARMs. Payment shock is the sudden and significant increase in your monthly payment due to a rate adjustment, which can make it difficult for you to afford your loan. Negative amortization is the increase in your loan balance due to paying less than the interest due, which can reduce your home equity and increase your debt.
- Predatory and risky lending: An ARM can also be a predatory and risky lending practice, as some lenders may use deceptive or abusive tactics to lure you into an ARM that you cannot afford or understand. Some lenders may offer you a low teaser rate that is too good to be true, or hide the fees, penalties, and terms of the ARM in the fine print. Some lenders may also target borrowers who have bad credit or low income, and charge them higher rates and fees
- To avoid falling victim to predatory and risky lending, you should be careful and vigilant when getting an ARM. You should do your research and compare lenders and loan options, and look for reputable and licensed lenders. You should also read and understand the loan agreement and disclosure, and ask the lender any questions or clarifications you may have. You should also know your rights and responsibilities as a borrower, and report any suspicious or illegal activities to the authorities
In conclusion, an adjustable-rate mortgage (ARM) can be a good or a bad option for you, depending on your financial situation and goals. An ARM can offer a lower initial rate and payment than a fixed-rate mortgage, but it can also have a higher interest rate and payment after the rate adjusts. An ARM can also expose you to predatory and risky lending practices, which can harm your credit and finances. Therefore, you should be careful and informed when choosing an ARM, and compare it with other mortgage options. You should also look for reputable and licensed lenders, and read and understand the loan agreement and disclosure. If you have any questions or doubts, you should ask the lender or consult a professional. Remember, your home is one of your most valuable assets, and you should protect it from any potential threats.