What Is The Difference Between A Fixed Rate Mortgage And An Adjustable Rate Mortgage (ARM)?
If you’re looking for a mortgage to purchase a home, you may have seen different types of loans available. Some of the most confusing for newcomers to the homebuying process include fixed-rate mortgage is an adjustable-rate mortgage (ARM) is. What’s the difference between them?
In short, the main difference between a fixed rate and adjustable rate mortgage is that fixed rate mortgages have an interest rate that is set when the loan is first taken out. On the other hand, ARMs fluctuate. Fixed-rate mortgage payments are consistent from month to month, while ARMs usually start comparatively lower but raise their rates over time.
That’s the basic understanding of a fixed rate mortgage and an ARM. However, there is more to consider when choosing between these types of mortgages. Let’s take a look at a number of factors that may influence your decision-making when seeking a mortgage .
Is a Fixed-Rate Mortgage or an ARM a Better Choice?
Determining whether a fixed-rate mortgage or an ARM is a better choice for your next home comes down to how you intend your future to be.
Fixed-rate mortgages are a good choice for those that have a solid career, growing family, or have made a decision to plant roots in a community for more than 10 years. Fixed-rate mortgages with terms of 15- or 30 years provides a consistency that enables homeowners to plan for the future through consistent payments. Best of all, if interest rates drop significantly in the future, homeowners can refinance into a fixed-rate mortgage at a lower rate.
On the other hand, ARMs are often chosen by first-time homebuyers that are looking to ease their way into homeownership without high mortgage payments. With lower interest rates at the beginning, it’s easier for those who are unaccustomed to homeownership to have more financial breathing room. ARMs are also great for those who may be forced to move due to their career, planning to have children in a few years, or those who want to be flexible if the area isn’t what they hoped it would be.
How Does an ARM Adjust over Time?
A portion of the interest rate homeowners pay for an ARM will be tied to a broader measure of interest rates. This is called an index, and the performance of the index. When the index of interest rates increases, mortgage payments go up. Vice versa, when this index declines, a mortgage payment will decrease.
However, there’s a catch: Not all arms decrease due to a cap. Some ARMs limit the maximum an interest rate can go, but some ARMs also limit how low your interest rate can go.
That’s why it is important to know how your ARM adjusts before taking out a mortgage.
To find out, find out how your ARM adjusts, ask your lender for the following:
- How frequently the interest rate will adjust
- How high the interest rate and monthly payments can change with each adjustment
- When do rates begin to increase after a grace period
- How soon your payment could go up
- If there is a cap on how high and/or low the interest rate could go
To plan for the future, you should also ask whether you would still be able to afford the mortgage if the maximum payments kicked in. If you find that it might be out of your budget, you may want to look elsewhere.
Avoid Interest-only ARMs
One of the ways that lenders entice borrowers is to offer interest-only mortgage payments for an introductory period - sometimes as much as 10 years. This is a substantial savings for those who are choosing an ARM. Seems like a good deal for those who may struggle to attain homeownership. What’s the catch?
In this configuration, a borrower’s monthly payments only pays the interest on the loan and doesn’t make a dent in the principal of the loan. This means that until you pay off the interest, you are not building an equity in the property. If you should choose to move or sell the property, you won’t have as much equity as you would if you had paid a portion of the principal each month.
And worse, after the promotional period ends, mortgage payments can increase substantially due to the principal now being included in the payments, but also the adjustable-rate that may increase due to market conditions.