Homeowners have a lot of tough decisions to make when buying a home. Anything and everything from the size of the home, neighborhood, and price to the color of the walls, age of the kitchen appliances, and type of flooring in the home is debated intensely.
But perhaps one of the most important things to do with buying a home, one of the main factors to consider, is the type of mortgage loan you should pursue. That is a pretty big undertaking for any homeowner, since it represents a pretty significant difference in how much you will pay monthly and how much you will owe overall.
Here we will talk about the two main types of mortgage loans in terms of interest rates - adjustable or fixed – and the advantages and disadvantages of each, so you can make an informed decision for your loan.
About Adjustable Rate Mortgages
Adjustable rate mortgages, or ARMs, are mortgages that have a variable interest rate. This means that the interest rate – the percentage of your overall loan amount that is charged to you annually over the term of your loan – will fluctuate depending on various conditions or factors. If you have heard of a variable-rate mortgage, that is the same kind of mortgage, just with a different term.
How Adjustable Rate Mortgages Work
As a rule, ARMs are more complicated than a fixed-rate mortgage. There are several types of ARMs out there, with different characteristics. Here we will talk in general about how they work financially so you can have a better understanding of their overall impact.
An ARM has a fixed-rate term at the beginning of the loan. In other words, when you sign on the dotted line and start making payments, for a period of time you will pay the same flat rate. This is the initial rate, and it does vary from lender to lender.
Many people take out ARMs that have initial rates lasting 12 months. The interest rate for the first 12 months will be low, but beginning in the 13th month, it will rise. You could have an initial rate last for as short as a month, or it could be longer. (The longer the initial period, generally, the higher the rate will rise over the term of the loan.)
The value of the interest rate, or how much interest you will pay, is generally tied to an index. Lenders will have various rates they use, such as the 1-year T-Bill, 6-month CD rate, 3-year T-Note, 6-year T-Note, etc. The most common index used today is the Treasury Constant Maturities (or TCM). An important note: If your loan is not tied to an index, it can be arbitrarily adjusted by your lender. Be cautious about those, and ensure you have caps on how much your rate can increase.
In essence, as the index goes up, so does your interest rate. Likewise, if the index drops, you can even pay less interest – although you shouldn’t count on it.
Common Terms of Popular ARMs
Here we will take a look at some common features of ARMs and discuss some common terms contained in the loan contract.
- Adjustment period: The time during which the interest rate changes from a fixed rate to a fluctuating rate
- Index rate: The value of the index to which the ARM is tied.
- Interest rate caps: A limit on how much your interest rate can increase. It is important to ask about caps on your loan, to avoid having a spike in your payment should the index go off the charts.
- Margin: Percentage points a lender adds to the index rate to calculate the ARM’s interest rate.
There are a few common terms in a typical ARM contract. For starters, you will determine the overall length of the loan, such as a 30-year loan, 15-year loan, etc. You will also see the adjustment period, and how often the interest rate will adjust over the course of the loan. Some contracts, for example, stipulate that your rate will adjust every six months, or every year.
The type of loan is another term. There are several different types of ARMs, from hybrid ARMs to option ARMs. Hybrid ARMs feature a fixed rate for a period of time at the beginning, following by an adjustable rate. Two common hybrid ARMs are 3/1 and 5/1, in which the initial period lasts for three and five years, respectively, followed by adjustment periods every year after.
Option ARMs allow you to choose between four monthly payment choices: a minimum payment; an interest-only payment; a 15-year payment; and a 30-year payment. Speak with your loan officer about the advantages and disadvantages of this particular type.
When Rates Change
The big feature about ARMs is the rate fluctuation. As discussed below, the interest rate fluctuates with the index rate to which the ARM is tied. When this change happens is determined by the loan’s adjustment period. The standard adjustment period is 1 year, so every 12 months after you begin your loan, your rate will change based off of the index.
Pros and Cons
Simply put, the pros of an adjustable-rate mortgage is flexibility. ARMs allow people to transfer the risk from the lender to the borrower in exchange for potentially-lower monthly payments for the borrower. Even if payments increase, sometimes the borrower still benefits from having an option to pay less in the first year than he or she would otherwise with a fixed rate.
The drawbacks to an ARM revolve around upside risk for the borrower. If the index rate increases – and it does happen – then the borrower could pay more monthly. Additionally, ARMs are inherently more complicated, especially some of the newer variants. It is easy to misunderstand the terms of the contract, and lenders aren’t always good at explaining them (or ethically ensuring that you understand them, either).
About Fixed-Rate Mortgages
Fixed-rate mortgages are far easier to understand for most people than ARMs, simply because they involve a fixed-rate that typically does not change over the course of a home loan. For this reason, they are the most popular type of loan between the two, especially for first-time homebuyers who are new to borrowing for a home.
How Fixed-Rate Mortgages Work
A fixed-rate mortgage has an index rate, an interest rate, and a loan term just like an ARM. That is where the two differ, though. A fixed-rate mortgage features the same flat rate throughout the term of the loan. That means for each and every payment, the interest rate will stay the same – thus allowing a borrower to more easily predict how much equity one builds up due to the amortization schedule. Plus, it allows a borrower to know the amount of overall interest one will pay by the time the term is over.
Let’s take a look at a standard type of fixed-rate mortgage. One popular FRM is a 30-year FRM at 4% interest (or whatever the current interest rate is). The interest rate is calculated by taking the index rate – usually the 10 or 30-year Treasury Note yield but potentially the prime rate that is tied to the Fed Funds rate – and adding margin, or additional percentage points, for creating the loan.
According to this loan, the borrower will pay 4% interest every month on the loan, each year, for 30 years. The exact proportion of interest to principal paid each month varies depending on the amortization schedule. Most today feature more interest paid on the front end of the loan and curving off until the final payments are almost all principal.
Common Terms of Fixed-Rate Mortgages
It is relatively easy to determine the terms involved with a fixed-rate mortgage. In essence, there are three factors that make up each FRM loan:
- Interest rate
- Compounding frequency
- Duration
The interest rate, as explained above, is the index rate plus margin. If you are being offered the prime rate, you are generally being offered the lowest rate the bank can offer you without losing money, which means prime rates typically go to the bank’s best or most qualified customers.
Compounding frequency is how often the interest on the total amount of your loan is compounded, or added to the principal. Most mortgages are compounded monthly.
Finally, duration is the term of your loan. Most are for 30 years, with 15-year terms a close second in terms of popularity. There are even 40 and 50-year terms out there, typically used with expensive housing that 30-year mortgages wouldn’t sufficiently cover.
The duration is of huge importance because it has a major effect on the size of your monthly payment. It also usually has a big impact on the interest rate that you will have to pay. A 15-year mortgage involves much-higher monthly payments than a 30-year mortgage, but the interest rate is often much lower. It is a trade-off, and people who take out 15-year FRMs want to pay off the mortgage faster. Doing so saves you more in the long run because you’ll pay less interest over the course of your loan, so while it is more expensive monthly, it is less expensive overall.
When Rates Change
As a rule, barring some form of intervention, fixed-rate interest rates do not change. They are intended to offer stable rates so the risk is transferred more to the lender than the borrower, which makes things, as a whole, easier on the borrower.
There are certain ways the rate can change, however. The most common method is through a refinance. When you refinance a fixed-rate mortgage, you are essentially paying off the old loan and taking out a new one with a lower interest rate, or a shorter term, or even a longer term (to reduce monthly payment amounts). People refinance because interest rates drop and they want to change the terms of their loan to take advantage of the lower interest rates.
The big drawback to refinancing for most people is the cost. Typically, most people pay 3-6% of their outstanding principal balance in fees related to the refinancing. This is due to loan origination fees, discount points (a one-time fee to get a lower rate), appraisal fees, and additional fees, charges, and penalties. You could also avoid refinancing if you have had the loan for a long time, or you have prepayment penalties, or plan to relocate within the next few years.
Rates can also be modified through a loan modification, undertaken generally when you are experiencing financial difficulties and are having a hard time making your payments. Since 2006, many people have had to pursue loan modifications because the interest rates when they purchased their home were far higher than after the housing market collapse in 2007-2008.
Choosing the Right Option
Overall, the type of mortgage loan you take out varies greatly depending on your individual circumstances. Evaluate your finances and consider why you are buying the home. If you do not want risk and intend to live in the home for a long time, a fixed-rate mortgage is probably best for you. If you do not mind risk and are willing to “gamble” a bit for a lower rate or more flexible payment options, an ARM might be your thing. You could even be a foreclosure investor who finds a foreclosure listing online and wants to finance it cheaply because you expect to sell it quickly.
In the end, it has been found that most borrowers pay less overall with adjustable-rate mortgages, that is not always the case – and even if it is, the risk and complication may not be your style. Your individual circumstances and situation will dictate which one is best for you. Use online mortgage loan calculators to make the best decision possible and pick out the type of mortgage loan that fits your financial needs, income, payment ability, and risk profile.
