Homebuyers have many decisions to weigh: Good school district in Fort Mill, SC, or an extra 2 acres of land 25 miles away? Gray or white paint in the living room? Should you ask the sellers to include the refrigerator or let it go with the sellers? But from a financial perspective, there’s one big decision you need to make first — and unlike an unfortunate paint color, if you make the wrong choice, it’s not a quick fix: You’ll have to decide whether you want a fixed- or adjustable-rate mortgage (ARM). If this is your first time buying a house, those may be foreign terms to you. If you’ve purchased a home in the past, the type of loan you got last time may not be the best option for this purchase.
Here’s how to decipher the differences between a fixed-rate mortgage and an ARM. Once you’ve gained a working knowledge of each option, use Trulia’s calculator to dig a little deeper into making a decision.
What is a fixed-rate mortgage?
A fixed-rate mortgage is the one you’re probably most familiar with: This type of mortgage lets you lock in your interest rate, so with a few minor exceptions, your monthly payment will remain the same over the life of the loan. Because of this predictability, if you have trouble budgeting, a fixed-rate mortgage might be your best option. “For some people, stability is important,” says Sylvia Gutierrez, a loan officer and author of Mortgage Matters: Demystifying the Loan Approval Maze.
So what’s the downside? You’ll probably have a higher interest rate on a fixed-rate mortgage than you would with an ARM. “If you want certainty, you are going to pay for it,” says Heather McRae, a senior loan officer at Chicago Financial Services Inc.
But you can save money with a fixed-rate mortgage if you can land a low interest rate. Your credit score and usage influences what interest rate you’re offered: The higher your score, the better your rate. Those with a credit score of 700 or above typically get the best interest rates on their mortgages. Finally, with fixed-rate mortgages, you have two main options: a 15-year term or a 30-year term. In most cases, a shorter term offers a lower interest rate, says Gutierrez. If you want a fixed-rate mortgage and you’ve had credit issues in the past, you might benefit from consulting a credit-counseling agency to help you repair your credit. Granted, it may take time to raise your score.
What’s an adjustable-rate mortgage?
An ARM is a mortgage that offers a lower fixed interest rate and payment for the initial period, but the rate can change over time, depending on market conditions. Since these loans are subject to changes in the market, an ARM borrower is essentially agreeing to unknown factors. “It’s a gamble,” says McRae. If you’re comfortable with payment flexibility and absorbing potentially higher rates, this could be your best option. McRae says ARMs can be ideal for investors who are interested in maximizing their property’s cash flow. “Since [ARMs] can provide a low monthly payment, they can ensure the investor receives the greatest margin between the monthly mortgage payment paid and the rent collected from their tenant,” she says.
An ARM may also be well-suited for buyers who plan to occupy the property as their primary residence only for a short time. A five-year ARM, for example, might be a good option if you’re planning to sell the property before that five-year period is up. The biggest drawback of this type of mortgage is that the rate can (and often does) increase after the fixed-rate period ends. The good news is, there are limits on just how high the rate can go. “The caps are an integral piece to choosing which adjustable-rate mortgage to go with,” says McRae. To see whether an ARM is right for you, ask the loan officer to provide a “worst-case scenario” for interest rate fluctuations, advises Staci Titsworth, regional manager of PNC Mortgage in Pittsburgh, PA. That can give you an idea of the highest amount you could have to write a check for — and then you can decide if your budget could cover it.
How do I choose between an ARM and a fixed-rate mortgage?
Now that you understand the differences, you can crunch some numbers to determine what type of loan is best for you. For example, if you get a 30-year fixed mortgage on a $ 200,000 loan at 4% interest, you’ll pay $ 955 per month and $ 107,804 in interest by the time those 30 years are up. Buy that same home with a seven-year ARM at an initial 3% interest rate, and your monthly payment drops to $ 843 for the first seven years of the loan. If you opt for the seven-year ARM and sell the home in five years, you would save $ 6,720 altogether — but if you stay in the home past seven years and the interest rate spikes, you could end up paying more in the long run.
Bottom line: Choosing an ARM over a fixed-rate mortgage can help you score a lower interest rate — and reduce your monthly payment — but only if you’re prepared to sell or refinance if interest rates start to have a negative impact on your finances.
What made you choose an ARM over a fixed-rate mortgage (or vice versa)? Share in the comments!
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