Fixed vs ARM: How to Choose Your Loan

Fixed vs ARM mortgage loan

By JP Dennis, Flyhomes Mortgage

When researching mortgage loans, you’ll decide between a fixed rate mortgage and an adjustable rate mortgage(ARM).

Let’s explore both to help determine which is best for you.

The basics

-An ARM loan typically begins with a lower interest rate, but will adjust after an initial period. If rates rise, the payments on the loan can become unaffordable.

-A fixed rate loan starts with a higher rate, but the interest rate and monthly payment do not change over the life of the loan.

Fixed Mortgages: Predictable, Stable, Simple

A fixed rate loan is the most popular because of its simplicity and predictability. You lock in a single interest rate, and your principal and interest payments stay the same for the life of the loan (but taxes and insurance may adjust).

You know exactly how much you are paying each month making it easier to budget, and plan for the future. If interest rates rise, you get to pat yourself on the back and tell yourself how smart you were to lock in such a low rate.

The primary disadvantage of a fixed rate mortgage is if interest rates fall and you want to take advantage of the lower rate, you’ll need to refinance. Refinancing can cost a few thousand dollars.

Also, when compared with ARM loans, a fixed rate loan typically has a higher starting interest rate.

While a 30 year term is the most popular you can choose a 20 year, 15 year, or 10 year term. Some lenders will even let you pick something in between, like a 23 year term.

Adjustable Rate Mortgages (ARM): Low Starting Rate

ARM loans typically have lower initial interest rates at the beginning of the loan term. This lower rate makes them attractive for buyers who have shorter timeline before they plan to sell the home, who plan to pay off the home quickly, or who believe interest rates are going down.

An ARM loan is paid off over a 30 year term, but has an initial fixed rate period from 1 month to 10 years. The most common are 5, 7, and 10 year ARMs. The shorter the initial term, the lower the rate. After the initial period is over the rate typically adjusts annually for the life of the loan.

How ARM loans adjust
There are two factors added together to determine a rate adjustment: the margin & the index.

The margin is determined by the lender and stays constant, but the index will vary. Two common indexes are the 12 month Treasury Bill (T-Bill) and the London Interbank Offered Rate (LIBOR).

As an example, if the margin is 2.25% and the index is at 3%, your rate would adjust to 5.25%.

Interest rate adjustments are capped. Knowing these caps tells you the maximum rate you could see, from which you can calculate the maximum monthly payment.

Initial Cap: The maximum amount the interest rate can change in the first adjustment after the fixed period ends.

Periodic Cap: Limits the interest rate change from one adjustment period to the next.

Lifetime Cap: Limits the interest rate increase over the life of the loan.

An adjustment example
Let’s look at the example of a $200,000 5/1 Loan (2/2/5) with a starting interest rate of 3.99%.

5/1 refers to the period that the rate is fixed (5 years) and the number of times per year after the fixed period that the rate will adjust (1).

2/2/5 refers to the initial cap, periodic cap, and lifetime cap, in that order.

The maximum rate and principal-and-interest payments for this loan would be:

The risk of an ARM loan lies in the unknown future adjustments. If the rates increase dramatically, your mortgage could quickly become a financial burden or even become too expensive to afford.

So how do you determine which loan type is best for you?

Think about your personal goals and risk tolerance, and balance those with the realities of our ever-changing marketplace. Here are 3 questions to help determine which loan is best for you.

1. Can I afford the possible maximum mortgage payment?
Don’t choose an ARM loan because the lower initial monthly payment is the only way you can afford your dream house. Instead, look at the worst-case scenario (rate adjusts to the caps) and if your stomach churns at the thought of that payment, a fixed rate is likely more suitable for you.

2. How long do you plan to keep the home?
If you plan to only keep the home for 3 or 5 years, it might make sense to opt for an ARM loan. You would have the benefit of the lower initial rate but sell the home before any adjustments occur, therefore reducing your risk. The lower rate and payment would allow you to save for a bigger home, invest for retirement, or even pay down your mortgage faster.

Notice that the question is not “How long do you plan to live in the home” but “how long do you plan to keep the home.”

Flyhomes can help you buy a new home and keep your current one as an additional source of rental income and an appreciating asset. While you may not live in the house for long, you may want to keep it.

3. What is the current interest rate environment?
Nobody has a crystal ball, so there is no predicting exactly where rates will be when your ARM loan adjusts. But we can acknowledge where we are now with what’s in the rear view mirror. Freddie Mac has monitored mortgage rates since 1971, and we’re currently in a historically low interest rate environment.

Want to find your best mortgage option?

or visit Flyhomes Mortgage

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Seattle, WA 98101
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