Fixed Rate Mortgages vs Adjustable Rate Mortgages

Let’s imagine that a friend of yours has begun shopping for her first mortgage and has asked you for advice. She’s considering purchasing either a 2-bedroom home or a 1-bedroom home in the same new development. She really wants the 2-bedroom, but she can just barely afford the payments on a 30-year fixed mortgage. Another friend suggested that she consider the type of mortgage that he got, a 3/1 ARM with a 2/5 cap. She wants you to help her compare the pros and cons of those two mortgages. She plans to live in her new home for 5 years. She has enough savings for a 20% down payment and six months of mortgage payments.

What is the difference in the monthly payments?

A. You might be able to afford the monthly payments on the two-bedroom if you get a 3/1 ARM with a 2% annual cap. They will be lower than the payments on the 30-year fixed mortgage, at least for the first 3 years.

B. There’s no reason to get an ARM if you can make the payments on a fixed rate mortgage. ARMs are too risky. Get the 30-year fixed mortgage and watch your budget.

Correct! The interest rates on the 3/1 ARM will be lower than the rate on the fixed rate mortgage for the first 3 years, so the monthly payments will be lower. However, you should NOT choose a mortgage based on the initial monthly payment. You have to consider the long-term costs. When the rate resets after 3 years, the payments will likely be higher than they would be for a fixed rate mortgage—in fact, they could be MUCH higher. That’s why it’s very important to consider how long you will stay in your new home.

Sorry, response “B” is incorrect. Though your monthly payments can change, you should still consider an ARM even if you can afford the payment on a fixed rate loan. The interest rates on the 3/1 ARM will be lower than the rate on the fixed rate mortgage for the first 3 years, so the monthly payments will be lower. However, when the rate resets after 3 years, the payments will likely be higher that they would be for a fixed rate mortgage--in fact, they could be MUCH higher. You should NOT choose a mortgage based on the initial monthly payment, but you should consider an ARM that is fixed for the length of time you will stay in your new home.

With an ARM, what will the difference in monthly payments be after 3 years?

A. It depends. If interest rates are not higher in 3 years, then your monthly payments on the ARM will still be cheaper than the fixed loan payments.

B. Even if interest rates stay the same for the next 3 years, your adjusted rate on the 3/1 ARM will almost certainly be higher than the interest rate on fixed rate loans, so your payments will be higher.

C. The ARM has a cap, so the rate will never be higher than the original rate + 2%.

Sorry, response “A” is incorrect. The initial rate on an ARM is set artificially low. Even if interest rates do not change, your payments may increase. The correct answer is B: Even if interest rates stay the same for the next 3 years, your adjusted rate on the 3/1 ARM will almost certainly be higher than the interest rate on fixed rate loans, so your payments will be higher.

Sorry, response “C” is incorrect. The 3/1 ARM in our example has a 2/5 cap, which means that the interest rate cannot be reset by more than 2% per year. However, the interest rate can be reset up to 5 percentage points higher than the initial fixed rate over the life of the loan.

Which mortgage is more expensive over 5 years?

A. The ARM will be more expensive because the interest paid in the last two years is higher.

B. The fixed-rate mortgage will be more expensive because the interest paid in the first three years is higher.

C. You can’t be sure which loan will be more expensive over 5 years. It depends on how much interest you pay on the ARM in years 4 and 5, and that depends on how much your interest rate goes up.

Correct! You can’t be sure which loan will be more expensive over 5 years. It depends on how much interest you pay on the ARM in years 4 and 5, and that depends on how much your interest rate goes up. Think about how much the ARM will save you in interest payments for the first three years, and decide if the savings are worth the risk of higher payments in the long run.

Sorry, response “A” is incorrect. You can’t be sure which loan will be more expensive over 5 years. It depends on how much interest you pay on the ARM in years 4 and 5, and that depends on how much your interest rate goes up. Think about how much the ARM will save you in interest payments for the first three years, and decide if the savings are worth the risk of higher payments in the long run.

Sorry, response “B” is incorrect. You can’t be sure which loan will be more expensive over 5 years. It depends on how much interest you pay on the ARM in years 4 and 5, and that depends on how much your interest rate goes up. Think about how much the ARM will save you in interest payments for the first three years, and decide if the savings are worth the risk of higher payments in the long run.

Which loan is riskier?

A. The fixed-rate mortgage is riskier because interest rates might go down and you'll be stuck with a higher rate.

B. The 3/1 ARM is riskier because after three years the payments are less predictable. They could possibly be much higher.

You are correct. Rates and payments can rise significantly over the life of the loan. What started as a 6% loan can become an 11% loan. Pay close attention to the details of your interest rate caps. The first time your rate is adjusted, the 2% cap might not apply.

Which is the right loan for me?

A. The 3/1 ARM is the right loan for you because the payments are lower for three years so you can more comfortably afford the two-bedroom home.

B. The fixed-rate mortgage is the right loan for you because you need to know exactly what you are going to pay each month for the life of the loan.

C. Neither loan is your best option. You could benefit from a fixed interest rate for 5 years because that's how long you will stay in that home.

You are correct. Neither loan is your best option. If you are sure you will live in your house for less than five years, you can get a 5/1 ARM and benefit from the lower interest rate on this adjustable rate mortgage and still have the advantages of a fixed rate mortgage for the period of time you own the house.

Sorry, response “A” is incorrect. Neither loan is your best option. If you are sure you will live in your house for less than five years, you can get a 5/1 ARM and benefit from the lower interest rate on this adjustable rate mortgage and still have the advantages of a fixed rate mortgage for the period of time you own the house.

Sorry, response “B” is incorrect. Neither loan is your best option. If you are sure you will live in your house for less than five years, you can get a 5/1 ARM and benefit from the lower interest rate on this adjustable rate mortgage and still have the advantages of a fixed rate mortgage for the period of time you own the house.

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