Fixed rate mortgages have an interest rate that remains constant for the duration of the loan. With a fixed rate mortgage, you know exactly what you are going to pay each month for the life of the loan. If interest rates drop dramatically, you can always refinance to get a better rate; if interest rates go up, you'll be smart for having locked in a lower rate.
With an adjustable rate mortgage (ARM), your monthly payments can change over time. Common ARMs have a fixed rate for one, three, five, seven or ten years. After that, the interest rate will be adjusted each year. The adjustment will be based on an index specified in the mortgage agreement. For example, the rate may be reset at 3% over the interest rate that the Federal government pays on Treasury Bills. Even if interest rates don't change, after it is adjusted the rate on the ARM will be higher than the rate on the fixed mortgage.
When you're shopping for mortgages, you'll see ARMs listed as 1/1, 3/1, 5/1 and so on. The first number indicates how many years the initial fixed rate will last. The second number tells you how often the interest rate will be adjusted thereafter (almost always a 1 to indicate an annual adjustment). In addition, ARMs often have caps on how much the interest rate can rise or fall. For example a common adjustable rate mortgage is a 5/1 ARM with a 2/6 cap. What this means is that the rate is fixed for the first five years and then the interest rate and payment is reset every year thereafter. With this loan, the maximum increase in any year (after the first five) is limited to 2% and the maximum increase during the life of the loan is limited to 6%.
The length of the loan
Another factor to consider when you're mortgage shopping is the length (or term) of the loan. With most conventional mortgages, you'll be making payments for either 15 or 30 years (several other terms, both shorter than 15 years and longer than 30 years are also available). If you choose the longer-term loan, you will end up paying more total interest but you will have lower monthly payments. If your credit score is weak, your mortgage broker or bank will probably recommend a longer term with lower payments.
If you select a 15-year loan, you'll pay less total interest and pay higher monthly payments. You also should be able to get a lower interest rate for a shorter-term loan. But your lender will probably want to see at least a good credit score (in the mid-600s) to approve this kind of loan.
To most people, doing the math on a mortgage is simply overwhelming. Lacking sophisticated financial tools, they are frequently left with only the ability to compare monthly payments. They would most likely choose to save $100 on the monthly payment without understanding the long-term costs and risks. Learning to compare the long-term cost of different mortgages can be challenging, but it's worth the effort. With a little patience you can do it, and you'll thank yourself in the end.
Do you want a fixed rate or an adjustable rate? Remember, your goal is not to get the lowest monthly payment. Your main goal is to minimize the amount of interest you pay over a defined period of time, the length of time that you are likely to be in the home. Though 30-year fixed rate loans are very popular, most people do not stay in their homes for 30 years. The average homeowner owns their home for about 7 years. So ask yourself how long you are going to be in your new home. If the answer is five years, then you ought to be looking for a loan that is fixed for only five years, not 30.
Consider this example of how you can save money with an adjustable rate mortgage. Let's assume that the interest rate on a 5/1 ARM is one percent less than the interest rate on a 30-year fixed rate loan. On a $150,000 loan, that means you save $7,500 in interest over that five-year period (1% x $150,000 x 5 years = $7,500). Put another way: if you get a 30-year fixed rate loan and are only there for five years, you spent $7,500 for interest rate protection that you didn't need ("protection" meaning that your interest rate won't change even if rates are rising in general).
Now consider the risk involved in choosing the 5/1 ARM in the same example. Imagine that you end up staying in the home for 10 years rather than 5, and that interest rates rise steadily in those 10 years. For the first 5 years you are happy because your rate is fixed at, let's say, 5%, while the interest rate on a 30-year fixed rate loan has risen from 6% to 6.75%. However, after 5 years, your interest rate resets, or is "adjusted," to 7%, and then is adjusted again the next year to 9% and continues to climb each year until reaching your cap limit at 10%. Suddenly your choice doesn't look so good. Your interest rate is up to 4 percentage points higher than it would be if you had chosen the 6% 30-year fixed rate loan in the beginning. The lesson here is that you need to be fairly certain about how long you will stay in the home when you choose an adjustable rate mortgage. Think about how much it will save you each year in interest payments, and decide if the savings are worth the risk of higher payments in the long run.
Deciding on the length of the loan
Your decision about the term of your mortgage basically boils down to the comparison presented in the table below. With a longer term, your monthly payments will be lower (or you might decide to buy a more expensive home). However, the lower monthly payments will cost you in the long run - your total interest payments will be much greater. In the example below, the borrower must pay $137,526 more ($231,676 - $94,150 = $137,526) in total interest in order to reduce his monthly payment by $435 ($1,634 - $1,199 = $435).
|Term||Interest Rate||Monthly Payment||Total Interest|
If you don't have much flexibility in your monthly budget then you would likely prefer the 30-year mortgage. But if you could afford the higher monthly payments then you could save a great deal of money in the long run. If neither of these options appeals to you then you should probably consider buying a less expensive home.