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Why fixed or adjustable rate mortgage (ARM)

Why Choose a Fixed or Adjustable-Rate Mortgage (ARM)

There are plenty of good reasons to choose a fixed-rate mortgage as well as an ARM (Adjustable Rate Mortgage). Choosing the one that’s right for you depends on how long you plan to live in your new home before selling, as well as your overall finances.

What’s the Difference?

A fixed-rate means fixed, monthly payments. From the first payment to the last, how much you pay will not change.

An ARM loan is expressed with two numbers, such as 5/1, 7/1, 10/1, etc. The first number represents the number of years for which the APR on the loan will be fixed (such as 5 years, 7 years, 10 years, etc.). The second number represents how frequently the rate will be adjusted once the fixed rate period has expired.

For example, the rate for a 7/1 ARM is fixed for the first seven years, and then the rate will be adjusted annually beginning with the sixth year. For a 5/5 ARM, the rate is fixed for the first five years and will be adjusted every five years thereafter. It is difficult to know ahead of time if your rate and payments will increase or decrease during those adjustment periods.

Rates depend on length of your mortgage

If you compare a $400,000 fixed-rate mortgage with a 5/1 ARM, it’s easy to see how time relates to savings for both options. With a fixed-rate mortgage and an interest rate of 5.00% APR and no down payment or mortgage points, you’ll pay just shy of $2,200/month for 30 years.

For an example of an ARM, let’s assume you’re approved for a 3.75% APR, with a 1.00% margin and maximum rate of 7.50%. With that loan, you’ll save $11,000 more than the fixed-rate loan after just seven years of payments. But if you choose to stay in the home for the full 30 years, the fixed-rate loan becomes the more economical decision, and saves you nearly $150,000 more than the ARM.

When to Choose a Fixed Rate

If you like consistency and financial predictability, a fixed rate is right for you. The stability of a fixed rate lets you know exactly what your payment amount will be over a long period of time.

When to Choose an ARM

If you don’t plan to live in your home for a long time, and want to afford more house, look closely at an ARM. The rates on an ARM can be lower than standard fixed-rate loans, which add up to lower monthly payments and more home-buying opportunities.

However, there are risks associated with an ARM. When the rate on an ARM adjusts annually, it does so based on an index plus a margin. Although there is a limit to how much the interest rate will increase), your monthly payment could go up.

Choose Wisely

Be honest with yourself about how long you plan to stay in your home. Then talk to a mortgage professional about your options. They’ll be able to make recommendations and show you the possible savings with both loan types.