Mortgages 101: Fixed-Rate Mortgages vs. Adjustable-Rate Mortgages Roger Odoardi When shopping for a mortgage, you should first understand the two main options that are available: fixed-rate mortgages or adjustable-rate mortgages. Adjustable-rate mortgages are known for their low initial costs, while fixed-rate mortgages have a reputation for providing borrowers with a solid sense of financial predictability. But even though each has its selling points, there’s likely one that’s better suited for you both personally and financially. What is an Adjustable-Rate Mortgage? Adjustable-Rate Mortgage Terminology You Should Know Advantages of an Adjustable-Rate Mortgage Disadvantages of an Adjustable-Rate Mortgage Ideal Adjustable-Rate Mortgage Borrower What is a Fixed-Rate Mortgage? Advantages of a Fixed-Rate Mortgage Disadvantages of a Fixed-Rate Mortgage Ideal Fixed-Rate Mortgage Borrower Keep Your Best Interests in Mind What is an Adjustable-Rate Mortgage? An adjustable-rate mortgage (ARM) will have a varying interest rate over the lifespan of your loan. However, ARMs do have a certain period at the beginning of the mortgage where you will see consistent, fixed payments and lower initial interest rates. This period of consistent monthly payments can last anywhere from one month to several years. After this initial period, your rates will adjust at a pre-determined frequency, such as a 5/1 ARM, which is fixed for five years, then adjusts every one year thereafter. That means you will be held to inconsistent payment requirements over the remaining terms of your mortgage. To put this into perspective, a 6% ARM could eventually end up at 11% in as little as three years if rates rise sharply. What You Should Know About Your ARM Before Borrowing Investing in an ARM can be risky, but it will likely have a high payoff in the long run. Interest rates are unpredictable and set by the market, so borrowers should fully understand their loan agreement terms and know how their ARM will adjust. Adjustable-Rate Mortgage Terminology You Should Know Adjustment frequency – The amount of time (typically a year) during which the interest rate on a mortgage will be adjusted. Adjustment index – The interest rate adjustment benchmark. Margin – The additional interest a borrower agrees to pay above the index rate typical. Caps – The limit to which the interest rate can increase each adjustment period. Ceiling – The highest number the interest rate can reach during the loan term. Principal – The non-interest portion of a loan. Interest rate – The percentage that a lender charges a borrower for a loan. Amortization – A gradual loan repayment in which installments are applied to both the principal and the interest Amortization schedule – A table that organizes amortization loan payments, including the interest and principal amount in each payment. Advantages of an Adjustable-Rate Mortgage One of the biggest advantages of an ARM is the initial low interest rate. This makes it easier for home buyers to get approved. Lenders can qualify borrowers using the lower payments, which means buying a larger, more expensive home is a greater possibility for the borrower. Borrowers who agree to a shorter adjustment period will often receive lower initial interest rates, saving money in the beginning of their loan term. Disadvantages of an Adjustable-Rate Mortgage Although there are advantages of an ARM, there are also a few disadvantages to be aware of. ARMs can be difficult for first-time home buyers to fully understand, and borrowers can be taken advantage of due to the flexibility lenders have with determining the loan terms. Although an ARM comes with a low initial rate, it is dependent on market fluctuation, which means that rates and payments will have the potential to rise considerably throughout the loan period, creating financial inconsistencies. If you have an ARM for long enough, the eventual interest rate will far surpass that of a fixed-rate loan. Ideal Adjustable-Rate Mortgage Borrower Here are a few situations in which a borrower should consider an ARM: Short-term homeowner If you’re not set on staying in the same location for long, an adjustable-rate mortgage might be your best bet. If you want to relocate or move into a bigger place before the introductory period of your mortgage ends, you’ll have reaped the benefits of a lower interest rate without having to deal with the fluctuating monthly payments. Borrowers expecting an income increase Borrowers who are expecting an income increase, like a recent law school graduate, will likely benefit from an ARM. They can take advantage of an initial low interest rate while preparing for a potentially increasing monthly payment in the future. Borrowers looking for an initial lower interest rate who aren’t worried about fluctuating interest rates If a homeowner is planning on selling their home within a year or two, taking out an ARM on a new property is a smart choice. After their previous home contract is closed, they may be able to pay off the entire ARM before the adjustment index increases. What is a Fixed-Rate Mortgage? A fixed-rate mortgage (FRM) maintains the same interest rate throughout the lifetime of the loan. This protects borrowers from increases in monthly mortgage payments because of rising interest rates and offers a strong sense of financial predictability. Even though your interest rate may be fixed, the actual amount you’ll pay each month with be dependent on the terms of your mortgage. The most common loan terms are 15, 20 or 30-year mortgages, with 30-year being the most popular choice because it usually offers the lowest monthly payment. Advantages of a Fixed-Rate Mortgage One advantage of an FRM is that the terms are clear and there is little variation between lenders. Consistent monthly payments that aren’t dependent on fluctuating interest rates give borrowers a sense of stability. Budgeting and planning for the future is a lot easier with a steady mortgage. Here’s an example of part of an amortization schedule of an FRM. In this example, the mortgage term is 30 years the principal is $100,000, the interest rate is 6.00%. You can see that both the principal and interest vary slightly, but the monthly payment is consistent. Payment Principal Interest Principal Balance $599.55 $99.55 $500.00 $99,900.45 $599.55 $100.05 $499.50 $99,800.40 $599.55 $100.55 $499.00 $99,699.85 $599.55 $101.05 $498.50 $99,598.80 Disadvantages of a Fixed-Rate Mortgage Although an FRM is the convenient choice for most first-time home buyers, there are disadvantages as well. When interest rates are high, qualifying for a loan is more difficult because the payments are less affordable. If you want to take advantage of falling interest rates, you’re going to have to refinance. Also, FRMs can’t be customized for individual borrowers because they are typically only listed on the secondary market. Ideal Fixed-Rate Mortgage Borrower Since fixed-rate mortgages are simpler to understand, they are commonly preferred among first-time home buyers. If you’re looking to plant your roots in an area where you can see yourself long-term, this loan option may be the best route for you. They are also a popular option for borrowers who aren’t looking to take the risk that comes with an ARM. Keep Your Best Interests in Mind While you may be gravitating toward a specific mortgage type, you should first consider both options thoroughly; for instance, your current and future personal and financial factors. While you might like the stability of a fixed-rate mortgage, if you have a career that relocates you every few years, it might end up costing you more in the long run. When it comes to a fixed-rate mortgage vs. an adjustable-rate mortgage, it’s important to understand that mortgage rates are constantly changing. Blue Water Mortgage is well-versed in both fixed-rate and adjustable-rate mortgages, and we’d love to help you determine which is right for you. Contact us today to speak with one of our qualified loan officers. Roger Odoardi Roger is an owner and licensed Loan Officer at the Blue Water Mortgage office in Hampton, NH. Roger graduated from the University of New Hampshire Whittemore School of Business and has been in the mortgage industry for over 20 years. Roger has originated over 2500 residential loans and is licensed in New Hampshire, Massachusetts, Maine, Connecticut and Florida.