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If you’re mortgage shopping, you may be overwhelmed by the number of options. To begin, start with a simple question: fixed-rate or adjustable? There are many different terms, points, and rates associated with each, but narrowing your search to a category can simplify the process.
Fixed-rate mortgages are the more traditional choice. You and a lender agree to a length of time, or term, and an interest rate. That interest rate stays the same throughout the duration of the mortgage.
Adjustable Rate Mortgages
Adjustable Rate Mortgages, or ARMs, are loans that have a fixed rate for an initial period of time. After that, the rate is determined by an economic indicator. For example, the notation “ARM 5/1” refers to an adjustable rate mortgage that has a set rate for the first five years of the loan, and then adjusts to a new rate every year thereafter.
Which mortgage is best one for you? The answer depends on the following factors.
How long do you plan to own your home?
One thing you’ll notice right away when shopping for mortgages is that ARMs have lower interest rates. The initial rates are lower because the lender is taking on less risk. With a traditional mortgage, if rates go up, the lender is stuck with a lower return.
There is still risk involved in the ARM even if you plan to sell the house. If demand drops in your neighborhood, you may have trouble finding a buyer. In that case, you’re stuck with the loan and a likely increasing interest rate.
On the other hand, if you plan to be in your house for the long haul, a fixed-rate can be a safer choice because you know up-front what the interest rate will be for the duration of the loan. Since interest rates are at historic lows now, they will likely increase in the next five years.
How much can you afford to put down?
An ARM can be easier to qualify for and provides you with an interest rate that you might not get without a 20% down payment. If you don’t have enough cash on hand to make a large down payment, an ARM might give you some time to build equity.
Refinancing your mortgage after the initial period is over can put you in a better position. You can use the equity you have in your home, plus whatever you’ve saved during that time, to put more money down and get a better fixed-rate mortgage.
Of course, this strategy is not without risk either. If the value of your home decreases, you may have a difficult time refinancing for the balance of the loan after the initial term. This would leave you stuck paying the higher interest rates of the ARM. If you can’t make the payments, you still lose your house, regardless of the equity you’ve established.
If you’ve got the cash to make a 20% down payment or are buying in an up-and-down housing market, a fixed-rate mortgage provides you with a greater level of security. Your mortgage payment stays the same from month-to-month and there’s less uncertainty.
What’s your risk tolerance?
Fixed-rate mortgages are the safer, more conservative choice. Adjustable-rate mortgages are the riskier alternative, but offer the possibility of savings.
If you have the room in your budget to accommodate a potentially fluctuating mortgage payment and enough security in your work, savings, and other financial priorities, an ARM does offer the potential to lower your monthly payment. If you’re confident that the value of your home will increase faster than interest rates, an ARM might be a wise investment.
If you’d rather have the security of a fixed-rate mortgage, there’s quite a bit to be said for that. If you’ve found the house you want to raise a family in, the stability of a fixed-rate mortgage may be desirable. If you’re trying to find the simplest path to homeownership, you may find the simplicity of the fixed-rate mortgage very appealing. It might be easier to be financially aggressive in other aspects of your life, and not put the place where you live at risk.