Friday, April 23, 2021 / by Anne Rose
Mortgage loans fall into two primary categories: fixed rate and adjustable rate (ARM). There are a few hybrid combinations of both types of mortgages, and some derivatives of each as well. A conversation with a mortgage broker that includes an in-depth review of personal finances will determine which products a home buyer qualifies for, and which makes the most sense for their personal financial situation.
A mortgage is the amount of money borrowed to pay the purchase price of real estate, plus the interest charged on top of the principal by the lender. The interest rate charged by mortgage lender, whether it’s a traditional bank, credit union, or government loan (FHA, VA, USDA, etc), is determined by the state of the economy and a number of other factors.
A Fixed Rate Mortgage is exactly what it sounds like: the interest rate is set at one figure for the entire term of the loan.
An Adjustable Rate Mortgage is a 30-year loan, which gives the borrower 30 years to repay the loan. An Adjustable Rate Mortgage (ARM) generally has two periods, the first initial fixed-rate period (5, 7, or ten years of the loan), and an adjustment period. During the initial period, the interests rate doesn’t change. After that time, the interest rate on the mortgage can go up or down based upon the loan’s benchmarks.
ARMs are attractive, especially to first time home buyers, because they often charge less interest during the initial period, offering a lower initial monthly payment than a fixed rate mortgage. During the adjustment period, ARMs can become less expensive than fixed rate mortgages if rates go down, but they can also become more expensive if rates go up.
For example, for the first years, a 5-year ARM would have a fixed-rate, and then the rate could go up or down for the last 25 years of the loan.
Short-term interest rates, including those used to construct mortgage indexes, correlate with an interest rate called the Federal Funds Rate, which can be explained in detail by a mortgage broker. The interest rate on an ARM is often capped with a maximum annual increase tied to the Federal Funds Rate, and capped again with a maximum life-time increase. There may be a variety of ARM products available to a borrower, and the benefits and pitfalls of each should be carefully evaluated.
A home buyer can make a decision about choosing an adjustable rate mortgage over a fixed-rate mortgage using the probability of selling before the end of the loan, and the probability of refinancing out of an ARM to a fixed rate mortgage. Refinancing is as detailed a process as applying for a mortgage, so that also needs to be considered from the vantage point of future family, career, and financial scenarios.
“When deciding if an ARM is a good fit, it’s good to consider how long you plan to stay in the home. If your lifestyle or work dictates frequent moves or relocations it might be a better fit than if you plan to be in the home long term,” advises Tara Jones, VP or Mortgage Lending, Guaranteed Rate.
In general, when mortgage rates are at 5 percent and above, borrowers find ARMs an attractive mortgage option, because the ARM interest rate can be more than half a percentage point lower than the rate on a 30-year fixed year mortgage.
Many people sell before they pay off their mortgage - 30 years is a long time to spend in one house - making nine years the average time obligated to a mortgage. In the above scenario of an ARM with an initial rate of one half a point lower than a 30-year fixed rate mortgage at 5%, a borrower of a $300,000 ARM would potentially save more than $8,000.
For first-time buyers, who are the most likely to stay in their home for a shorter period before they either upsize to accommodate a family or sell to make a career move, the question is often whether to buy at a higher interest rate - even if that rate is only 1/2 a percent higher - when an ARM could save them money in the short run.
Even with that consideration, when mortgage rates are under 5%, real estate experts often advise against gambling with an ARM.
“When fixed rates are as good as they are in the current market, I don’t advise my clients to consider an ARM,” says Becky Brown, co-owner and Broker/Realtor®.
For home buyers, a valid consideration is that as mortgage rates increase, affordability decreases. Weighing the options between a Fixed Rate Mortgage and an ARM, and all the variations of each, can assist with affordability. While interest rates might go up in the future, they may also drop. Being informed and conducting a thoughtful analysis of local trends, national indicators, and a home buyers personal tolerance for risk are important in determining the best mortgage product to buy a home.