The choice of mortgage is one of the most important factors when refinancing or purchasing a home. Certain distinctive characteristics of fixed-rate and adjustable-rate mortgages can assist you in making your choice.
| Adjustable Rate Mortgage | Fixed Rate Mortgage | |
|---|---|---|
| Interest rate | Fixed for the first few years, then occasionally resets | fixed during the loan's term |
| Interest rate risk | The borrower bears the risk of market interest rate increases. Borrowers gain if interest rates decline. | The lender bears the risk that interest rates will rise. Borrowers can refinance if interest rates drop, but they typically have to pay prepayment penalties and other expenses. |
| Affordability | For the first several years, monthly payments are initially smaller. | Because the lender assumes the interest rate risk and charges the borrower a premium for it, monthly payments are greater when the interest rate is marginally higher. |
Key differences between fixed rate loans and ARM
Interest Rate
The interest rate that the bank charges the borrower on a fixed rate mortgage stays constant for the term of the loan, which is typically 15 to 30 years. The interest rate on an adjustable-rate mortgage (ARM), on the other hand, is adjusted on a regular basis (typically annually following an initial period of two, three, or five years). A 3/1 adjustable rate mortgage (ARM) has a fixed interest rate for the first three years and then adjusts annually until the loan is paid back. Typically, lenders are prohibited from arbitrarily raising ARM interest rates. An ARM's reset interest rate is established using a benchmark market rate, such as LIBOR.
In the case of a long-term fixed-rate mortgage, the lender bears the risk of future interest rate increases, or interest rate risk. Thus,
- The interest rate on a 30-year fixed-rate loan will be greater than that of a 15-year fixed-rate mortgage since longer-term fixed-rate mortgages are more costly.
- An ARM's initial interest rate is lower than that of any fixed-rate mortgage; that is, the interest rate on a 5/1 ARM for the first five years will be lower than the interest rate on a 15-year fixed-rate mortgage. Therefore, ARM loans will initially have lower monthly payments.
Risk
Over the course of the loan, there is a chance that the interest rate (and consequently, the monthly payments) will increase with an ARM. It's possible that ARM's cheap interest rates will only be available for a short time. It could be alluring to lock them in with a fixed-rate mortgage during periods of low interest rates.
A fixed-rate mortgage carries the corresponding risk of interest rates dropping or being low for a long time. Although it is typically possible for borrowers to refinance in order to benefit from reduced interest rates, there are occasionally prepayment penalties for loan closure, and refinancing is always subject to expenses (closing costs, appraisal fee, etc.).
A fixed-rate mortgage carries the corresponding risk of interest rates dropping or being low for a long time. Although it is typically possible for borrowers to refinance in order to benefit from reduced interest rates, there are occasionally prepayment penalties for loan closure, and refinancing is always subject to expenses (closing costs, appraisal fee, etc.).
Pros and Cons
You can be sure of the monthly amount you owe the bank when you have a fixed rate home loan. It doesn't change during the course of your loan, so you won't ever have to worry about market fluctuations. In contrast, if the market is doing well, you might choose to pay less interest on a variable rate mortgage. Additionally, some lenders typically cap the maximum interest rate that can be charged. You may be sure that you will pay reasonable fees in this method. ARMs are more inexpensive because of their reduced monthly payments (at least during the first few years).
How to choose
Here are some tips to choose which mortgage to take:
- Selecting a fixed rate mortgage will lock in your interest rate if interest rates are already extremely low and are not likely to drop much else.
- An adjustable rate mortgage is the better option if you anticipate paying back a significant amount of the principle in the early years. For instance, you take out a $300,000 loan, but you want to pay back $60,000 per year for the first three years, in addition to your monthly payments.
- If the ARM's cheaper interest rate enables you to purchase a property but the fixed-rate would result in excessively high monthly premiums, proceed with caution. You should only take out an ARM loan if you anticipate an increase in your income in the future. Otherwise, you won't be able to make your payments and the interest rate will reset higher after the initial period.
- Make every effort to select loans without prepayment penalties. In the event that interest rates decline, this increases your flexibility to refinance.
Popularity
One nation where fixed rate mortgages are more common is the United States of America. Variable rate mortgages are more common than fixed rate mortgages in the United Kingdom, Australia, and New Zealand.
0 Comments