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May 2016

Fixed-Rate or Adjustable-Rate Mortgage: How to Choose the Right One

Buying a house is one of the most exciting (and overwhelming) things you may do in your adult life. But before you can move into that new space that’s all your own, you have to find a way to pay for it. Chances are, like most homebuyers, you’ll be financing your home with a mortgage loan. And with that loan comes a great deal of decisions.

One of the first mortgage choices you’ll have to make is whether to take out a fixed-rate or an adjustable-rate mortgage. So let’s take a deeper look at your options.

What is a fixed-rate mortgage?

With a fixed-rate mortgage, the interest rate is set when you take out the loan, and it will not change during the life of the mortgage. The advantages of a fixed-rate are fairly obvious, as it’s linked to its predictability. While the amount allocated to principle and interest each month may vary, __the total monthly mortgage payment never changes__. However, keep in mind your taxes and insurance can change, with both a fixed- and adjustable-rate loan.

Personally, the predictable nature of this fixed-rate made choosing this loan type an easy decision for my own home purchase, as it made for easy budgeting.

The other advantage is that fixed-rate loans are easy to understand, and they don’t vary much from lender to lender. The downside to fixed-rate loans is that the interest rate and payment may be higher than the initial rate of an adjustable-rate mortgage.

Hypothetically, let’s suggest you took out a fixed-rate loan for $300,00 with a 3% interest rate.

Your monthly mortgage payment would be $1,265, and it would the same every month for the life of your loan, excluding taxes and insurance.

*Disclaimer: This scenario assumes your loan option allows no down payment , with no private mortgage insurance (PMI).*

What is an adjustable-rate mortgage (ARM)?

The interest rate of an adjustable-rate mortgage may go up and down during the duration of the loan. The advantage is the interest rate will likely start lower than a fixed-rate loan, but the disadvantage is that it can go up. Typically, an ARM works like this – for some preset number of years, the interest rate remains unchanged. After that initial rate period ends, the rate changes (up or down) based on predetermined intervals. While the unpredictable nature of this loan could seem risky, it’s actually a great option for many homebuyers. Did you see movie “The Big Short?” Don’t worry; those exotic, dangerous ARMs that once existed are now mostly gone. You’ll instead find more manageable, conservative options that are increasingly competitively priced.

Depending on your unique circumstances, such as the length of time you’ll own the home, you could actually save money with an ARM.

Initial rate period

The initial rate period is an introductory interest rate on a mortgage for a certain length of time. The initial rate period varies from loan to loan. It can range from one year to several years. Even if industry interest rates are stable, after the initial rate period ends, your rates and payments could still change significantly.

The adjustment period

With most ARMs, the interest rate will change after the initial rate period ends. The frequency of which it changes is based on each individual loan.

Interest rate caps

When choosing an ARM, you also should consider the interest rate caps, which places a limit on the amount your interest rate can potentially increase. There are three kinds: an initial cap, a period adjustment cap, and a lifetime cap.

An initial cap is the amount the interest rate can increase the first time it adjusts after the initial rate period ends. A periodic adjustment cap limits the amount your interest rate can adjust from one adjustment period to the next, following your initial cap. In addition, a lifetime cap limits the interest rate increase over the total life of the loan. If you’re considering an ARM, ask a lender to calculate the highest monthly payment you may ever have to pay. Make sure you’re financially comfortable with that amount. If you’re trying to compare ARMs, consider the rate caps. Two different lenders may offer the same initial rate, but their caps may be very different.

Caps help give you a better picture of any potential increases in your payment.

Interest rate floors

While you’re probably most concerned with the caps from an increased rate, another thing to consider is your rate may potentially decrease. Some ARMs have a “floor” interest rate, which is the lowest it can go. In other words, even if industry rates severely decrease, your rate may not be able to decline at all if you’ve already reached your “floor.”

The index and margin

The fully adjusted rate, or the fully indexed rate, is based on the sum of two percentages: a constant number called a margin and a variable number called an index. When you total the margin and the index, you get your new rate. Remember, your index can vary up or down, depending on the security of the investment bond that it’s tied to (ex: U.S. Treasury bonds, LIBOR, etc.).

Let’s look at a purely *hypothetical* example.

If you have a 5/1 ARM, that means your rate doesn’t change for the first five years of your loan, and then it can adjust annually after that initial rate period. Imagine you have an initial rate of 3% on a $300,000 loan. Now let’s say your margin is 2%. Your index is 2.46%. And let’s suggest your caps are structured 5/2/5. This means the rate can change no more than 5% initially (initial cap), 2% periodically (periodic adjustment cap), and 5% total over the lifetime of the loan (lifetime cap).

After those first five years, your rate could fluctuate up and down each year, but keep in mind your potential interest rate will never exceed more than 8%__, because the lifetime cap is 5%. *Disclaimer: This scenario assumes your loan option allows no (0) down payment, with no private mortgage insurance (PMI). *

If you’re thinking about taking out an adjustable-rate mortgage, make sure you understand how your ARM adjusts.

  • What is the initial rate period, meaning how long is the rate fixed and when can it begin to change?

  • What is the adjustment period, meaning how frequently will the interest rate change?

  • What are all of your adjustment caps?

  • What is the total amount an interest rate can increase – your lifetime cap?

So now that you understand the differences between a fixed-rate and adjustable rate mortgage, how do you choose which one is right for you? Consider the following.

  • What is your risk tolerance? Are you completely comfortable with your monthly payment possibly changing with an ARM?

  • Is your income enough to cover the highest possible mortgage payment of an ARM, if the rate goes up?

  • Will you be taking on any other sizeable debts? Consider those in your potential budget.

  • How long do you plan to own the home? If you know you’re only planning to own a home for five years and you have a five-year ARM initial rate period, then it could be a good loan option to consider.

Making so many loan decisions can be extremely stressful, but just keep your end goal in mind. Don’t forget to ask your loan officer questions if you’re ever uncertain throughout your loan process. You could be choosing new paint colors before you know it.