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Getting a home is a long-cherished part of the American Dream. Sadly, this dream was put on hold or snatched away from many people once the Great Recession took the world by storm. Fortunately, all recessions eventually do come to an end. As job growth begins to increase and life moves on, many people will once again look to become homeowners.
Since not many people have the hundreds of thousands needed to purchase a home in cash, they turn to borrowing mortgage loans. Mortgage loans come with either fixed interest rates or adjustable interest rates, both of which serve their own, unique purpose. A closer examination of these mortgage types can help prospective borrowers determine which one they should borrow and use towards the purchase of a home.
Fixed-Rate Mortgages
Fixed-rate mortgages are what most borrowers initially consider. As their name implies, fixed-rate mortgages have a stable interest rate that does not increase or decrease throughout the mortgage loan’s lifetime. Consequently, these loans have a set monthly payment that does not change.
Fixed mortgages are available with either 30-year or 15-year terms. 30-year fixed loans have higher interest rates than their 15-year counterparts because the financing is intended to be repaid over a longer period of time. Debt that is due to be repaid over a longer period ties a lender’s money up, so it cannot be re-lent to others. As a result, lenders assign higher rates to longer-duration borrowing in order to make up for that lost money.
An example can help illustrate how these two types of fixed mortgages work.
Let us assume a borrower obtains a mortgage loan for $100,000. If it is a 30-year loan with 7 percent interest, then the borrower will be required to pay $655 each month. If a borrower has a 15-year FRM at 6.75 percent then he or she must pay $885 each month. Clearly, when considering these examples strictly on a month-to-month basis, the borrower will save more money by going with the 30-year mortgage loan.
However, the borrower will be paying more money in interest over the long run. Some borrowers will be inclined to repay their debt faster using a 15-year home loan, allowing them to save money earlier in the future. In contrast to this, other borrowers will be more inclined to save money each month.
Adjustable-Rate Mortgages
Adjustable Rate Mortgages (ARMs) have interest rates that increase or decrease, depending on the index the rates are tied to. However, those fluctuations don’t immediately take effect. Rather, they’re subject to a period of fixed-interest, which is called the “initial rate period.” This “initial rate period” lasts anywhere from several months to several years.
Typically, lenders offer 1-year or 5-year ARMs, wherein the specified year amount refers to the “initial rate period.” Once the “initial rate period” passes, the ARM’s interest rate will increase or decrease. Some borrowers try to repay their ARM before the “initial rate period” ends.
However, once the “adjustable” period begins, borrowers shouldn’t panic. Lenders cannot move the interest rate around at will. Rather, rates are tied to certain financial indexes and move in accordance to them on yearly basis. If an index increases, then an ARM borrower can expect the interest on their loan to increase, and subsequently their monthly payment will also increase. On the other hand, if an index decreases then the borrower can expect their interest to decrease as well, which means their monthly payment will also fall. One of these indexes, the LIBOR, was recently the subject of a massive scandal that involved the artificial manipulation of the index by several large multinational banks.
Borrowers who decide to apply for ARMs must recognize and understand that they will be exposed to more risk since the interest rates on their mortgage loans can increase over time. However, depending on their personal financial situation, as well as the rate at which they repay their mortgage loan, they may end up paying less than they would have with a fixed option.
More information on these mortgage types and other forms of financing can be found at loans.org.
I went with fixed rate. May not always be the best deal, but it helps me sleep easier at night.
Cat recently posted..5 easy ways to save at the gas pump
Yeah that would be one less thing to worry about. For some people that peace of mind is priceless.
Same here. If I had a crystal ball, I might have went with an adjustable rate mortgage.
Jacob @ iheartbudgets recently posted..Budgeting Infographic
With a fixed rate mortgage, you at least are making the decision knowing all variables. A variable rate is good if you know you are going to sell the property in some years.
Rohit @ The Money Mail recently posted..Roth IRA
Even if you know you’re going to sell the house soon, you could still end up in a period where you’re paying a less favorable interest rate.
We have a fixed mortgage as it’s not worth it to me to take on any extra risk and I always know what our rate will be. Mortgage paperwork is way too much to work through as it is without throwing variable interest into the equation.
John S @ Frugal Rules recently posted..Working From Home – A Mom’s Perspective
That does make future planning pretty difficult when you don’t know if your mortgage rate will stay low. The risk may seem worthwhile, but who wants to take a big risk with that kind of money and that valuable a possession?
The rates on an adjustable rate mortgage can be attractive, but I would never use one. You can really get hurt by the rates in the long term.
Sean @ One Smart Dollar recently posted..How to Deal with Debt Collection Agencies
I wonder how many people get too tempted by those low rates. With rates at an all time low, they should realize that they are bound to increase eventually. Who knows how much that will be.
I’ve done the whole adjustable rate mortgage thing and I wish I never did. My payments went up a lot but luckily I was able to refi before things got to bad.
Chris @ Stumble Forward recently posted..How to Manage Your Money Better – 7 Tools to Help
Sorry to hear that you had to learn the hard way. Being able to refinance can save some people, but that comes at a cost.
I was considering an adjustable rate mortgage when we were refinancing, however I was told that ARMS couldn’t be amortized over 15 years, so we just went with a 30-year fixed note as it wasn’t much different than the ARM.
I do think fixed loans are best for the majority of people (and the majority of situations), however there are places where ARMs can make sense.
Jason @ WorkSaveLive recently posted..4 Easy Debt Reduction Strategies – Explained
We might have to have a little chat about when an adjustable rate makes sense. I’ll probably be deciding on a mortgage later this year. So I’m going to have to figure out what’s best for my situation.
I have a fixed rate mortgage and do not talk much about ARM loans. When working in mortgage collection, I would talk to so many ARM loan borrowers. Most got burned by the increase in rates, very few had a drop in payment. I would only use one if you plan on getting out of the home in a few years, but that may not work in your favor.
Grayson @ Debt Roundup recently posted..Effective Tips on How to Avoid Getting into Debt
Seeing that first hand is sure to make you avoid adjustable rate mortgages. Since my future mortgage will be long term, I should probably play it safe and go for a fixed rate.
When we were looking to buy back in the spring, we toyed with the idea of a 5/1 ARM because the size house we could afford at the time wasn’t what we really wanted long-term. Our idea was to get the adjustable rate for the lower interest rate, and continue saving to a larger house, and sell in 4-5 years. But the back persuaded us to stick with fixed rate in case our plans changed, or we weren’t able to sell in a timely manner.
Edward Antrobus recently posted..December 2012 Net Worth Update
That’s probably the best route when you aren’t absolutely sure of your plans. Wanting to sell in 4-5 years doesn’t necessarily mean that you can do so at the price you want. So it would be a bit of a gamble.
I started with a blended mortgage (both fixed rates) and refinanced into one, fixed-rate mortgage. I like the stability of the fixed rate, but I also have to say that I’ve certainly admired the insanely low rates my friends with ARMs have been enjoying over the past 2 years!
The Happy Homeowner recently posted..2013 Financial, Personal and Household Goals
They’re probably pretty happy about those rates too, but at the same time they’re probably apprehensive about what is going to happen to those rates in the coming years.
I think ARM’s make sense for certain situations. I’d look at the highest possible payment that could happen and see if I’d be OK paying that before I’d sign on for one. Our home and rental property are both fixed. I like the stability of it.
Kim@Eyesonthedollar recently posted..Options for Diversifying Your Investments
You’re right that you do need to consider the highest payment and whether you could cover that. That way you home at least wouldn’t be at risk of foreclosure. Still, it might be a more comfortable situation to be able to keep putting that extra money towards retirement savings.
We have a fixed rate mortgage but I would definitely consider an ARM in the right situation. Our house should be paid off within 3 years so if someone offerered me an ARM with an insanely low rate and no prepayment penalties and the numbers added up, I would take it.
Holly@ClubThrifty recently posted..Credit Card Churning: A Year in Review
When you’re that close to paying it off I could see the risk being worthwhile. With a larger amount left on your mortgage it could end up being a big mistake.
Adjustable mortgages are great when you know that you will be moving homes in a few years. They are also good when you are sure you will be able to qualify for a refinance a few years down the road. Otherwise always go with the fixed.
Being able to qualify for a refinance wouldn’t always protect you though. Sure it would allow you to take advantage of lower rates, but if rates increased you’d be out of luck.