Buying a home is an exciting, yet complicated, process. A home buyer who plans to secure a mortgage when financing a home has a dizzying array of options available. Although there are a number of hybrids and variations, mortgages loans come in two basic types—adjustable rate mortgages, or ARMs, and fixed rates mortgages. Understanding the advantages and disadvantages of your options will help you make a more informed decision.
Fixed Rate Mortgages
As the name implies, when you enter into a fixed rate mortgage the interest rate is fixed at the time of purchase and will remain the same throughout the life of the loan. Although a traditional fixed rate mortgage contemplates a 30 year repayment schedule, you may have the option to select a shorter or longer repayment period. Your monthly payments will remain the same throughout the life of the loan. Interest, however, is front-loaded, meaning that your payments during the first few years of the loan will be predominantly interest with only a small percentage of the payment going toward the principal.
Among the advantages to financing a home with a fixed rate mortgage is that there are no surprises. Your payments will never change even if inflation causes current interest rates to surge. Buying a home with a fixed rate mortgage is often easier for a first-time buyer to understand as well. The terms of an ARM can be very confusing which sometimes leads to misunderstandings on the part of the buyer. With a fixed rate loan, budgeting is much easier for the buyer because there are no surprises or changes during the life of the loan.
One disadvantage to a fixed rate mortgage is that a borrower must refinance if interest rates fall significantly. This means additional closing cost fees to the borrower. In addition, first time borrowers may not qualify for the amount of loan they need because the initial monthly payments are usually higher under a fixed rate mortgage.
Adjustable Rate Mortgage (ARM)
Financing a home with an ARM also has advantages and disadvantages. Under the terms of an ARM, the interest rate is subject to change. Typically, the loan starts off at a lower interest rate than a fixed rate mortgage but adjustments over the life of the loan can raise the interest rate substantially and the monthly payments along with it. One advantage to an ARM is that a buyer may be able to qualify for a higher loan amount than with a fixed rate mortgage because the lender will use the lower payment amount reflected by the initial interest rate when qualifying the buyer. With a lower monthly payment, a home owner can save or invest the money saved each month. An ARM is often a good option when a buyer doesn’t plan to stay in a home for more than a few years because the interest rate will typically stay relatively low during the first few years of the loan.
Among the disadvantages of an ARM is the uncertainty surrounding the monthly payments. Although most ARMS have built in caps that limit the amount the interest rate can change each year and/or over the lifetime of the loan, a borrower may still end up with an interest rate substantially above that of a fixed rate at some point during the lifetime of the loan. In addition, the terms of an ARM can be very confusing to a borrower because of the flexibility a lender has to change the interest rate and therefore the monthly payments.
There are also a number of hybrids that combine aspects of both a fixed rate mortgage and an ARM. Hybrids come in numerous forms and offer a veritably unlimited combination of advantages and disadvantages for financing a home. Be sure to consult with your Better Homes and Gardens Real Estate agent about all of your mortgage options before choosing one.