With today’s mortgage interest rates still clinging to historic low levels, it’s a very good time to buy or refinance a home. You want the lowest possible rate you can get when it comes to any type of financing, but especially with home loans because there’s so much money involved – even a tiny rate difference can make it lot more expensive to borrow the money.
You’ve probably heard of two of the most common types of mortgages, Fixed-Rate loans and Adjustable-Rate loans (ARM). As you can tell by their names, the interest rate plays a big part in how they work. But they’re very different. With either loan, even with an extremely low interest rate, you need to be very careful to choose the right one. They work differently. They’re designed for different purposes. Choosing the wrong loan could create financial difficulties down the road. Fortunately, it’s easy to tell them apart and make the right choice.
Here’s the most important difference between the two loans:
- A Fixed-Rate loan has an interest rate that will not change throughout the life of the loan
- An Adjustable-Rate loan has an interest rate that can change, multiple times, throughout the life of the loan
With an interest rate that does not change, Fixed-Rate loans allow you to enjoy stable monthly mortgage payments throughout the life of the loan. There are variety of Fixed-Rate loans available, and all feature the same benefits:
- Predictable monthly payments help make it easier to manage and maintain a household budget
- With a “fixed” interest rate, you’re protected against bad economic times, inflation, and interest rate increases (today’s rates can’t stay low forever)
- They’re available in a very wide variety of loan types, including conventional, jumbo, and government-backed FHA, VA, USDA and other loan programs
30-year and 15-year Fixed-Rate loans are the most common Fixed-Rate loans.
30-year Fixed-Rate Loan:
- Features low monthly payments because they’re spread over a long period of time
- More is paid toward interest over the life of the loan because there are more payments
- A great loan if you plan to stay in your home a long time and want to maintain low monthly payments
15-year fixed-rate loan:
- Features slightly higher monthly mortgage payments because you have to pay the loan off sooner
- Features a lower interest rate than a 30-year Fixed-Rate loan
- Saves you thousands of dollars in interest payments over the life of the loan
- With a shorter term the loan is paid off much sooner
One disadvantage to a Fixed-Rate loan is if the rates drop, you’re stuck with that rate. But as low as they are today, getting a Fixed-Rate loan to buy or refinance a home isn’t much of a risk at all. In fact, it’s a good bet.
Adjustable-Rate Loans (ARM)
ARMs have an interest rate that will vary, or adjust, over the life of the loan. They begin with an introductory period during which the rate does not change, that is actually lower than a Fixed-Rate mortgage. Typically, this period ranges from one to ten years. After this time, the rate can change. It will go up or down to reflect or match where the current market rates are overall. If you get an ARM with rates where they are today, you’d have a mortgage with an extremely low interest rate and monthly payments. But if, or when, they go up before your rate is scheduled to adjust, you could experience a dramatic increase in your monthly payments. It’s a very good loan if you use it for the right reasons.
The most common types of Adjustable Rate Mortgages are the 3/1 ARM, 5/1 ARM, 7/1 ARM, 10/1 ARM and the standard ARM.
The first number represents the introductory period when the interest rate is fixed and will not change. Afterwards, the rate can change once every year for the remaining term of the loan. For a 5/1 ARM, the interest rate stays the same for the first five years, and can then change every year for the remainder of the loan. A standard ARM has an initial fixed-rate period of six months to a year.
When the rate on an ARM changes, it’s only applied to the remaining years and balance on the loan, not the original terms – so there are some savings to be captured there. There are also caps, or limits, to how high or low the rate can adjust each year, as well as over the life of the loan.
Benefits to getting an ARM:
- It’s a great loan for people who know they’ll move before the rate changes
- You can get some of the lowest interest rates and monthly payments possible
- Lower payments could allow you to afford a larger house or live in a nicer neighborhood
- The money you save with low monthly payments can be invested or used for other purposes
- They’re also available in a wide variety of conventional and government-backed loans
Important considerations before getting an ARM:
- It’s essential that you clearly understand how your loan will work
- Know what the limits on rate increases/decreases are each year, over the life of the loan, and the dates they adjust
- Plan ahead for the rate adjustment – if you don’t sell the home before then, consider refinancing if the new rate will increase your monthly payments
- Keep in mind, if your property value goes down, or your income drops due to a job loss or other event, refinancing might not become an option
- You should calculate, in a worse-case scenario, if you’ll be able afford the maximum rate and payment increases in the loan
With interest rates as low as they are, now is a fantastic time to buy a new home or refinance your mortgage with either of these two loans. A Fixed-Rate mortgage will lock you into a rate with low payments you might not have to refinance in the future. Having an even lower rate during the introductory period of an Adjustable-Rate mortgage could help you save a bunch of money.
Contact a PrimeLending home loan expert who will be happy to explain the differences in more detail, and help you choose the right loan for your situation.
From the PrimeLending blog by Michael Nevin