Many people do not even consider anything other than a 30-year fixed interest rate and, in many circumstances, that is likely the best option anyway. As with just about anything, however, there are pros and cons to both fixed rates and adjustable rates. Understanding them, and what they mean in the context of your situation, can help you make the best decision for your financial future.
Fixed rates offer an extremely significant benefit for most people: security. If you use a 30-year fixed rate mortgage, you know your interest rate will be the same every month of every year for as long as you have that loan. Your total housing payment may increase or (rarely) decrease due to changes in taxes or insurance(s), but your principal and interest (P&I) payment will remain the same.
The con associated with fixed rates is often not even considered: the 30-year fixed rate is probably the highest currently available for the loan program you are using, assuming it offers other repayment terms. You see, yes, you get the added security, but you do pay for that added security. Still, for many people, that security is invaluable and well worth the higher rate.
Adjustable rate mortgages (ARMs), as the name suggests, do not offer the same security as a 30-year fixed rate, but many types of programs do offer ARMs that have fixed rates for 1, 3, 5, 7 or sometimes even 10 years before they begin adjusting. Typically, the shorter the fixed period the lower the starting interest rate. The pro here is, of course, the lower payment attached to the lower interest rate.
Another positive for ARMs that is often overlooked is that the payment is based on the current loan balance at the time of adjustments to the interest rate. This could create a situation where, if you were able to pay your loan down considerably before the first adjustment, your payment could go down even if your rate were to go up.
It probably goes without saying, the biggest con or drawback to an adjustable rate is that the rate can go up.
So, when might an ARM be a good option?
There are several situations when an adjustable rate option may be worth exploring:
- When the outlook for mortgage rates strongly suggests rates will go down. Adjustable rates can go down, too. If you purchased a home in 2005 on an adjustable rate loan, post-adjustment interest rate on your loan through at least 2016 would be significantly lower than the starting rate was.
- When you are very confident you will not have the same mortgage in 3, 5, 7 or 10 years. There are some caveats that you should also consider here, such as how much you will owe, market trends, and the likelihood of being able to sell and recoup your investment; however, if you are confident that you will not own the home in a few years, why pay for 30 years of rate security when a shorter fixed period will suffice?
- If you know you will be able to pay the mortgage down significantly or you expect your ability to afford a higher payment to improve. Unless there is some particular event that you can count on influencing your circumstances, such as a forthcoming lump-sum receipt of cash or some all-but-guaranteed change in your income, this should be a very tentative situation. Most of us can say “hey, I’m sure I’ll be making more in 5 years,” but it is not always a given that the growth in our income will outpace the growth of our other expenses.
As always, if you would like more information on this or any other topic to help you make informed decisions, I am just a phone call or email away. Feel free to contact me at your convenience.