Adjustable vs. Fixed Home Loans: What’s the difference?
Some decisions can be more challenging to make than they may seem. One of them is whether to choose adjustable vs. fixed home loans when purchasing a home.
It can be overwhelming, especially for first time home buyers. So, how do you go about choosing the best type of mortgage loan for you?
You want to be sure that the decision you make is paramount, so you will not regret it later.
Your lender presents you with two options: Adjustable vs. Fixed home Loans. Before you make any critical decision, it’s imperative to understand the differences between the two options.
Let’s explore them and see the effects each might have on your borrowing cost.
What is an Adjustable-rate Mortgage?
The name “adjustable-rate” suggest that the rates can change to fit circumstances. For an adjustable-rate mortgage, the interest rate is determined by an index. If you’re wondering what an index is, according to cfbp it is
The index is a benchmark interest rate that reflects general market conditions. The index changes based on the market, and is determined or maintained by a third party. Changes in the index drive the changes to your interest rate.
In simple terms, an adjustable-rate loan monthly payments can either scale high or low. There exist many indexes. Loan paperwork is what identifies which index a given adjustable-rate will follow.
The initial monthly payments of adjustable-rate loans are lower than the current market rate adjustable-rate loans for a given period. The most popular being 5/1 ARM. Which offers a fixed price for five years, then the rates reset once every year.
The rates will either go up or down. Some lenders may price a 7/1 ARM or a 3/1 ARM, which means the borrower gets seven or three years of fixed interest rate; after that, the rates start to fluctuate.
Common terminologies worth mentioning
Initial adjustment cap; states how much the interest rate can rise after the first time change when the fixed-rate expires
Subsequent adjustment cap – shows how much the new interest rate can get to in the adjustment period after the fixed-rate expires
Lifetime adjustment cap – shows how much the interest rate can increase in total during the lifetime of the loan
- Adjustable-rates are favorable in a decreasing interest rate environment
- It is ideal for borrowers who plan to live in one place for a short period
- ARM offers lower rates in the early years of the loan. Borrowers can afford more-expensive homes
- Borrowers can take advantage of decreasing rates without having to worry about refinancing
- When the rates change – it’s possible it could go up and become very expensive for you to manage the payments hence lose your home.
- It can be a challenge to budget in the environment where the rates keep changing
- It is not suitable for those whose plan to have the loan for a more extended period
- Can be more difficult to understand
What is a Fixed-rate home loan?
Fixed-rate mortgages do not have varying interest rates. Instead, the rates stay the same for the life of the loan.
Your monthly payments won’t change whether the market rates go up or down.
The standard payment period is 30 years. If you wish to pay off quickly, the period can be 20 years or even 15 years.
What makes this loan attractive and favorable to many borrowers is its predictable nature. You know clearly how much you need to pay-off.
Generally, consumers should prefer longer-term Fixed-rate mortgages to short-term. Why?
The shorter the term – the higher the monthly payment. But the interest rate will be lower.
On the other hand, the longer the term, the lower the monthly payment and the higher the interest rate.
In a Consumer Expenditure Survey done by the United States Bureau of Labor Statistics – in the period between 2004 and 2014 – the percentage of 30-year mortgages held rose from 47% to 70%.
Things were quite different for a 15-year mortgage whereby the total number held decreased from 17% to 13%.
The statistics imply that many people embraced the 30-year Fixed-rate mortgage, which is also the least risky instrument. [United states department of labor]
- Rates and payments don’t change, and the borrower knows how much they’ll pay hence safe
- Constant rates make it easy for consumers to budget for their money
- There are no complicated concepts such as the 5/1 ARM thing for consumers to struggle with making it favorable for first-time buyers.
- They’re more popular as compared with the non-fixed-rate options
- It’s not favorable in a decreasing interest market. If the rates fall – the consumer will have to refinance and pay some more borrowing and cost fees
- Fixed-rate house loans have higher rates as compared with ARM making it difficult for some people to qualify
Should you get an Adjustable-rate or a Fixed-rate Mortgage?
The answer can be straight-forward. A fixed-rate mortgage is the better choice for many consumers. Its benefits surpass the drawbacks.
The fact that a borrower knows how much to pay makes it even more appealing. But before you can get excited about anything, let’s look at some facts and figures.
The average rate of a standard 30-year fixed mortgage is 4.64% (Mortgage Bankers Association).
On the other hand, the average interest rate on the most popular 5/1 ARM is 3.85%.
Looks nice right?
Now note this; Mortgage providers use the index together with the margin (a unique percentage) to determine the total ARM rate you pay.
Let’s shade some light.
For instance, if the index, say, 0.5% and the margin is 2.65%, you’ll pay 3.15%. (several online tools that can help you).
The terms of your ARM will determine how high or low your interest could go after five years or so. [CNBC]
In the U.S the most popular form of home financing is the 30-year level-payment fixed-rate mortgage. [Source]
According to the Federal Reserve Bank of New York, many borrowers attempt to form an expectation about future rates when choosing a mortgage, rather than to consider only current rates. [Source]
During the last week of January 2019, the size of the average fixed-rate mortgage was USD 280900 while that of an ARM was USD 688400. Source: as captured by the Market watch from Mortgage Bankers Association.
The statistics tell us that most consumers tend to go for the ARM because of the lower initial rates that it offers. It is affordable, and there may be a chance to refinance into a fixed-rate in the future.
The above facts and figures may look contradicting at some points. It’s hard to decide whether to choose an adjustable-rate or a fixed-rate mortgage.
Below are some points for you before you make that final decision.
- The period you plan to stay in the home. Are you going to live in the house for just a few years? Or a much longer time?
- What will happen to you when the interest rates rise? Will you still be able to pay off your monthly payments?
- What’s the current interest rate environment? If the rates are high, an ARM may be the best deal.
- If your decision seems to incline towards an adjustable-rate loan – what are the terms? How does the index appear? When is the adjustment made?
The ball is now in your court.
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