It’s the age-old question when it comes to taking out a home loan: should you go for an adjustable-rate or fixed rate mortgage?
The answer to that question depends on a number of factors, including your specific financial situation and the temperature of the current market.
Fixed-rate mortgages lock you into a specific interest rate for the entire loan term. Many borrowers like the idea of having a rate that never changes so that they can budget more easily and not have to deal with fluctuating monthly payments.
Adjustable-rate mortgages (ARM), on the other hand, mean that the rate – and therefore the monthly payments – can change throughout the loan term. Many borrowers choose to risk the potential change in rate and payments in order to take advantage of the more attractive interest rates, as initial ARM rates tend to be lower than those of fixed-rate mortgages.
But the decision to choose one type of mortgage over the other is not so cut and dry. There are important factors to consider before making your decision, as one can end up being a lot more expensive than the other.
Here are some questions to ask when considering adjustable-rate mortgages versus fixed-rate mortgages.
How Long Do You Plan To Live in Your Current Home?
If you’re planning to stay put in your home for many years, a fixed-rate mortgage is typically recommended, especially if you can lock in at a relatively low rate. On the other hand, if you have plans to make a move some time over the short-term, an adjustable-rate mortgage might make more sense.
Your monthly loan payments will be lower, allowing you to save a little more each billing cycle. If you’re moving before the adjustable rate period starts, you shouldn’t be vulnerable to any significant interest rate adjustments.
What Are Interest Rates Like Right Now?
The temperature of the interest rate environment is a crucial factor to consider before deciding between an adjustable-rate versus fixed-rate mortgage. When rates are high, fixed-rate mortgages are more expensive. You’d be locking in at a high rate for a few years, making your mortgage more expensive and leaving you stuck with a high rate that could go down at some point in the near future.
In this case, you could be missing out on significant savings. When rates are high, an ARM might make more sense because their initial rates are lower than fixed-rate mortgages. If rates dip shortly afterward, you’ll have the benefit of having lower payments.
However, if rates are particularly low, locking in with a fixed-rate mortgage might make more financial sense, especially if rates are expected to rise in the near future. By locking in at a low rate, you won’t have to worry about it rising for the next few years until your term is up and your mortgage is due for renewal.
Would You Be Able to Comfortably Make Mortgage Payments if Rates Increase?
An important factor to think about when considering an adjustable-rate mortgage is what your tolerance for risk is. Will your current or future income be able to comfortably support a more expensive mortgage if the interest rate rises on your ARM? Even the slightest increase in rates can make a big difference on your mortgage payments.
While the initial monthly payments on an adjustable-rate mortgage might be affordable for you today, what will they be like if rates rise in the near future? If the initial mortgage payment amount is already at the limit of what you can afford, an adjustable-rate mortgage might be too much of a financial risk for you. Instead, a fixed-rate mortgage will afford you with more predictable payments to fit within your budget.
What About “Caps”?
Adjustable-rate mortgages involve rates that fluctuate on a regular basis, but in order to make sure they don’t swing too wildly, they come with “caps.” These caps ensure that there are limits set on how far interest rates can go when the loans are adjusted. They can also limit how much monthly payments can increase.
If you’re leaning towards an ARM, be sure to identify exactly what the caps are first.
Caps are expressed as a ratio of three numbers:
Initial adjustment cap – This represents the interest rate limit on the first adjustment after the fixed-rate period is up. A cap of five, for instance, would mean that the new rate can’t go up any more than five points at the first rate adjustment compared to the original rate.
Subsequent adjustment cap – This represents the cap for each subsequent adjustment that the rate can rise over the rate during the first period.
Lifetime adjustment cap – This represents the limit on how much the interest rate can rise over the life of the mortgage.
It should be noted that some ARMs may cap the limit on how much your monthly payment increases, but not necessarily the limit on the interest rate. In this case, you could be stuck with payments that don’t cover the entire interest amount that’s due on your home loan.
Instead, whatever interest payment amount outstanding will be added to your total debt amount, leaving you stuck paying interest on top of interest and making your mortgage more expensive than it was when you first started paying it. These are known as “negative amortization loans.”
Before you take out an ARM, be sure to compare rate caps when comparing home loans. Two different loans might have the same rate during the initial period, but different rate caps can play a key role in which one would be more affordable. In addition, it’s important to determine the highest payment that you could end up paying on a mortgage before signing on the dotted line.
How Often Can Your ARM Loan Adjust?
Once the fixed-rate period expires on an adjustable-rate mortgage, the loan adjusts on a regular basis. While an annual adjustment tends to be typical, the adjustment period can be longer or shorter. It’s important for you to determine the frequency of your loan adjustments in order to more accurately budget for your mortgage payments.
The Bottom Line
There is definitely some appeal to adjustable-rate mortgages since their initial interest rates tend to be lower than fixed-rate mortgages. On the other hand, fixed-rate loans offer the benefit of remaining constant throughout the loan term, making monthly payments much more predictable and allowing borrowers to budget more easily. Before you make your decision, be sure to closely assess your financials and the current market, and speak with a seasoned mortgage professional who will be able to guide you in the right direction.