Are you buying a new home? Whether your new home is on the range or in the subdivision, you are probably wondering what the best type of mortgage is for your situation.
The difference between a fixed-rate and an ARM is the first thing you need to consider before applying for a mortgage.
Fixed-Rate Mortgages Explained
Fixed-rate is exactly that. Your mortgage interest rate stays the same the entire length of your mortgage. It never changes.
Some of you may lean toward a fixed-rate loan because you like how it sounds. You may have plugged all the variables into a mortgage calculator, and you like knowing that your loan rate is going to stay the same for the length of your loan.
Perhaps you think that your mortgage payment will be easier to budget for if you know it will be the same every single month for the next fifteen to thirty years.
You may be the type of person who enjoys going to the same mediocre restaurant every Friday night, not because the food is great, but because you know what to expect when you order their chimichanga platter.
ARM Mortgage Explained
An ARM or an Adjustable Rate Mortgage changes. The interest stays the same at the beginning of the mortgage, but then changes with the interest rate index.
When it comes to your finances, it is better to fight against that urge to do what you think is “playing it safe” because what you regard as “safe” might not be the most fiscally responsible option. Consider an adjustable-rate mortgage. I know the word “adjustable” may make you feel like you need to breathe into a brown paper bag, but it is not as scary as it sounds.
Yes, adjustable rates can change over a period of time, which means your house payment may increase, but the benefit is that it starts at rates lower than the fixed-rate option. Did the term “lower rates” make you perk up your ears?
A Situation When an ARM Makes Sense
Monica and Doug are borrowing money for their first home. The home is a fixer-upper, and Monica is excited to try out some of the techniques she has seen from watching hours of home shows on TV for the last several years.
Doug is beginning his career, but he anticipates that if things go as expected, he will have a significant jump in salary soon. Monica and Doug both know this is not the home they would like to be living in when they decide to start a family. The house is small and is in a less-than-desired school district.
The couple qualifies for a 5/1 adjustable-rate mortgage. This means that the rate is fixed for the first five years of the 30-year-loan. The “1” indicates that after five years, the loan rate can adjust every year after the initial five.
Since Monica and Doug are planning to improve the home and then move within the next five years, the adjustable-rate mortgage makes the most sense to them. They plan to enjoy the lower house payments so they can use some of that money to work on the home. Hopefully,
Monica’s renovations will allow the couple to increase the value of their home in the short time they own it, and then they will be able to use that profit to purchase their forever home in a more desirable location.
Even if Monica and Doug’s plans don’t work out and they end up being in the home longer than five years, that does not mean they are jumping off a financial cliff. This is where the fine print of the loan document becomes especially important. Your ARM has caps.
Periodic adjustment caps
Periodic adjustment caps limit the amount your interest rate can increase from one adjustment to the next. If you have a periodic cap of 2%, and your current rate is 4%, then the subsequent modification to your loan can only go up to 6%.
There are also lifetime caps on your loan. Let’s assume that Monica and Doug have a lifetime cap of 6% and their current rate is 2%, then the highest their mortgage rate can reach is 8%.
Payment caps limit the amount your actual payment will increase after an adjustment. If you have a 6% payment cap, and your house payment is $1,500. Your mortgage payment can’t jump any higher than $90 additional dollars a month.
There are also different types of ARMs available in the marketplace. Talk with your lending institution about hybrid ARMs, interest-only ARMs, and payment-option ARMS to learn if one of these products can work for you.
An adjustable-rate mortgage is not the right answer for everyone. Start by reading about mortgages. Learn as much as you can on your own. Then sit down with your lending institution and your financial planner to figure out the right option for your situation.