When you are in the market for a mortgage, one of the many decisions you’ll have to make is whether to apply for a fixed-rate loan or an adjustable rate mortgage (ARM). Both can be beneficial, depending on your situation. Learning the difference between them can ensure you get the right product for your financial goals.
Fixed-rate mortgages (FRMs) are just as their name suggests – loan with a fixed interest rate, a rate that never changes over the course of the mortgage. The obvious benefit of this type of loan is that your monthly payment, as well as your interest costs, will be predictable and therefore easier to plan into your budget. The interest rate on an FRM will be determined by several factors including the overall market rates, your personal credit history and the size of your down payment.
FRMs are a great choice for those who are ready to settle down and plan to stay in their new home for years and even decades to come. They are also a smart choice when mortgage interest rates are low by historical standards. Locking in a low rate can save you thousands of dollars over the life of the loan.
An adjustable rate mortgage starts out with a low interest rate for a set period of time, after which the rate can fluctuate. The initial rate can sometimes be lower than an FRM by as much as one percentage point. One of the most popular types of ARM loans is the “5/1” ARM. The “5” means that the initial low rate will be fixed for the first five years and the “1” means that the rate will be allowed to reset every year thereafter.
While the mortgage rate you get on an ARM is still based on your credit and down payment, the adjustments will be closely tied to a specified market index. This could be a public interest rate such as LIBOR (the London Inter-Bank Offer Rate) or it could be a private interest rate formula developed by your lender. If the index rates are moving higher, your interest rate will climb, but if the index falls your interest rate could actually decrease. The risk with ARM loans, though, is that when your mortgage is in the resetting phase, market interest rates might jump up dramatically, pushing your mortgage payments higher than you can afford.
However, for the savvy mortgage borrower, ARM loans can be a great boon. They can be an excellent choice for those who do not plan to stay in their current home for more than a few years. In this case you could take advantage of the super low initial rate and sell your home before the rate is allowed to reset higher. ARMs can also be helpful for first-time buyers because it often easier to qualify for an adjustable rate mortgage rather than a fixed-rate one. This could give a novice buyer the ability to afford more house than they otherwise could. ARM borrowers should just make sure that they have the income to cover higher monthly mortgage payments if they keep the loan past the initial fixed-rate period.
In the end, the difference between ARMs and FRMs may come down to personal preference. Some buyers will prefer the stability of a fixed interest rate while others will be excited to save some money upfront and possibly have more flexibility for relocation. Both can save you money, depending on how high current market rates are.
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