An Examination of Fixed- and Adjustable-Rate Mortgages 25 Comments
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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 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 (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.