Fixed rate mortgages and adjustable rate mortgages are the 2 primary mortgage types. Both have advantages and disadvantages, depending on the borrower’s needs. The majority of borrowers choose a fixed rate mortgage, due to its affordability and stability. An ARM can be attractive to borrower with its lower initial payments.
FIXED RATE MORTGAGE
- A fixed-rate mortgage charges an interest rate that doesn’t change for the life of the loan.
- The most common terms are 30 year, 20 year and 15 year with the 30 year being the most popular. Because of the longer life, the payment on a 30 year is lower than other term mortgages. The shorter the term, the higher the payment.
- Main advantage of a fixed-rate mortgage is the payment remains the same which makes budgeting easier for the borrower.
- Borrower doesn’t need to worry about interest rate fluctuations.
- A disadvantage is when interest rates are high, qualifying for a mortgage can be more difficult as the payment is higher.
ADJUSTABLE RATE MORTGAGE
- Interest rate is fixed for a specific time period and will adjust after the initial fixed period is completed. After the initial fixed period, the lender will apply a new rate based on the index plus a set margin. The fixed rate period is typically between 3 and 10 years. The shorter the fixed period will generally have the lower interest rate.
- Most ARMS have limits on how much the interest rate can change following the fixed period and the maximum rate that can be charged.
- Assume a lender is offering the following: 5/1 Libor ARM at 3.5% with 2/2/5 caps.
5/1: The initial rate on the loan is 3.5% for 5 years
5/1: After 5 years, the interest rate can adjust once a year
Libor: The annual rate adjustment is based on changes in the 1 year Libor rate.
2/2/5 Caps: The 1st number is the maximum adjustment allowed the 1st time the rate adjusts in year 6 or 2%. The maximum interest rate can’t be higher than 5.5%.
2/2/5 Caps: The 2nd number is the maximum adjustment allowed for each annual adjustment beginning in year 7. The interest rate can’t adjust more than 2% above or below the rate in the previous year.
2/2/5 Caps: The 3rd number is the maximum adjustment overall. The interest rate can never go higher than 8.5% in this example (3.5% + 5% = 8.5%)
- Main advantage is a lower initial payment. This might be an excellent choice if borrower plans to resell during the fixed period.
- If borrower believes that interest rates will stay near current levels or go lower, and ARM may also be a good option.
- In a rising interest environment, a borrower will be faced with increased payments and might be forced to refinance.