Understanding Rates for Mortgages: Should You Get an Adjustable-Rate or a Fixed-Rate Mortgage?
Although most people think of the 30-year fixed-rate mortgage as the standard, there are a few different options for home buyers to consider. The payment structures for these loans are unique, so their costs over the life of the loan might differ a great deal. This guide distinguishes between adjustable-rate and fixed-rate mortgages, and shows when each could be a wise option for buyers.
What Is a Fixed-Rate Mortgage?
One reason that the fixed-rate mortgage tends to be fairly common for home buyers is that it is relatively easy to understand. With a fixed interest rate loan, borrowers have a payment of principal and interest that is the same amount every month for the whole loan. The interest rate is set at the beginning and does not change unless the homeowner refinances the mortgage. The monthly payment stays the same, with the exception of changes in property tax liability and insurance premiums if there is an escrow added to the monthly payment.
How Does an Adjustable-Rate Loan Work?
The standards of an adjustable-rate mortgage (ARM) are different, compared to a fixed-rate loan. When a borrower gets a mortgage with an adjustable rate, the payment is likely to change for the length of the loan. At first, the loan has an initial rate that is guaranteed for a set amount of time. This period might last a couple years, or as long as five years. After that, the interest rate will adjust at a defined interval. Borrowers can identify these periods in the loan description. For example, a 5/1 ARM has an initial rate set for five years, and can go up or down once a year after that.
Home buyers who are seriously considering an ARM should ask about the index and margin of each loan. ARMs are indexed to a particular rate, such as the 1-Year London Interbank Offered Rate (LIBOR). The various indexes may have similar rates throughout the year, but they are rarely the same. In addition to the index, the lender adds a margin to determine the updated rate for the ARM. If the initial term lasts for a few years, interest rates may change significantly. Each loan usually has a cap on the amount the rate can change. Homeowners with this type of loan need to watch the rates of the index, so that they can plan for possible increases in their monthly payments.
How Does the Term Length Affect the Monthly Mortgage Payment?
Most people have at least heard of a 15-year fixed-rate or 30-year fixed-rate mortgage. An ARM usually lasts 30 years, although there are a few lenders offering shorter options. People who have the ability to make a higher monthly payment might consider choosing a lower term. Mortgages that last 15 years allow a homeowner to pay off the loan in half the time. This requires a bigger monthly payment for either kind of loan, but leads to lower interest payments and a faster payoff. In addition, selecting a shorter loan duration often comes with a lower interest rate. This is because the lender takes on the risk of the mortgage for less time, and can offer better rates as a result.
Why Would Buyers Prefer an Adjustable-Rate Mortgage?
Many financial experts recommend trying for a fixed-rate loan whenever possible. However, there are times when an ARM may make more sense. In a straight comparison of interest rates, adjustable-rate mortgages usually come lower than fixed-rate loans. This has a number of practical impacts for buyers, including:
- increased buying power (because less money is taken up by interest)
- lower monthly payments
- flexibility to lock in a lower rate later
For borrowers with limited or growing income, the lower cost of an ARM might provide the ability to buy a home in the first place.
When Is a Fixed-Rate Loan a Practical Choice?
When it comes to the largest debt most homeowners will have to pay, predictability is key. Knowing what the payment will be from one year to the next makes it easier for buyers to prepare for their future financial needs. Interest rates tend to change only a little from month to month. After many years, the average annual rate might be double what it was when the buyer got the mortgage in the first place. People who can lock in a fixed-rate loan at a reasonable cost at the beginning can choose to stick with the loan for the duration.
Getting a mortgage usually involves a discussion of the kinds of terms a buyer would prefer. Understanding the difference between fixed-rate and adjustable-rate mortgages makes it easier for borrowers to decide which one will best suit their needs. That way, once they apply, they can go straight to comparing each loan offer. Home buying can be a fun and exciting time, but Alexandria home buyers should include a review of their options for mortgages before beginning to look for homes to buy.