When buying a home or refinancing, one of the most crucial decisions is choosing your mortgage. Fixed-rate and adjustable-rate mortgages have some unique features that can help inform your decision.
Key differences between fixed rate loans and ARM
In a fixed rate mortgage, the interest rate the bank charges the borrower remains the same throughout the entire duration of the loan (usually 15 to 30 years). On the other hand, interest rate on an adjustable-rate mortgage (ARM) is reset periodically (usually every year after an initial period of 2,3 or 5 years). A 3/1 ARM means that the interest rate on the loan is fixed for the first 3 years but changes after that once a year until the loan is repaid. Lenders usually aren't allowed to raise interest rates on ARM arbitrarily. When the interest rate on an ARM is reset, it is determined by using a benchmark market rate e.g. LIBOR.
- Longer term fixed-rate mortgages are more expensive i.e. interest rate on a 30-year fixed-rate loan will be higher than a 15-year fixed-rate mortgage
- Initial interest rate on ARM is lower than any fixed-rate mortage i.e. interest rate for the first 5 years on a 5/1 ARM will be lower than the interest rate on a 15-year fixed-rate mortgage. So monthly payments will be lower with ARM loans initially.
The risk with an ARM is that the rate of interest (and therefore, monthly payments) may rise over the lifetime of the loan. The low interest rates on ARM may not last beyond the initial period. So when interest rates are low, it may be tempting to lock them in with a fixed-rate mortgage.
Correspondingly, the risk with a fixed-rate mortgage is that interest rates may either fall or stay low for an extended duration. While a borrower can usually refinance to take advantage of lower interest rates, sometimes there is a prepayment penalty for closing out the loan; and there is always fees (closing costs, appraisal fee etc.) associated with refinancing.
Pros and Cons
With a fixed rate mortgage loan, you can be certain of the amount you owe the bank on a monthly basis. It remains the same through the entire term of your loan, never stressing you out if there is a fluctuation in the market. A variable rate mortgage on the other hand, gives you the option to pay less interest, if the market conditions are favorable. Also, some lenders usually put a cap to the highest interest rate that can be charged. In this way, you are assured of paying moderate rates. Due to lower monthly payments (at least in the first few years), ARMs are more affordable.
How to choose
Here are some tips to choose which mortgage to take:
- If interest rates are already very low and unlikely to go much lower, choose a fixed rate mortgage and lock in your interest rate.
- If you expect to repay a substantial portion of the principle in the early years, choose an adjustable rate mortgage. e.g. You take a $300,000 loan but are planning to repay $60,000 (as extra payments; over and above your monthly payments) in the first 3 years.
- If the lower interest rate on the ARM allows you to buy the home but the fixed-rate would raise monthly premiums too high, then be careful. Only take the ARM loan if you expect your income to rise in the future, because if your income does not rise and the interest rate resets higher after the initial period, then you will no longer be able to afford to make your payments.
- Always try and choose loans that do not have a prepayment penalty. This gives you more flexibility to refinance if interest rates fall.
The United States of America is one country where fixed rate mortgages are more popular. United Kingdom, Australia and New Zealand are countries where variable rate mortgages are more popular than the fixed rate mortgages.