A home is often a great investment, but it’s also one that requires making some critical financial decisions. With the help of your mortgage banker, you’ll need to decide what type of loan program you need, as well as which mortgage structure will help advance your long and short-term financial goals. Perhaps the most fundamental question of all, however, is whether you should choose a fixed or adjustable rate mortgage. In this piece, we’ll consider five questions you should ask yourself to decide which one is best for you.
While it may be difficult to predict, your future plans for your home matter. If you intend to refinance to remodel, move to a new home, or for other reasons within a short period of time after closing (generally less than 10 years), Adjustable Rate Mortgages (ARMs) could be a good choice. ARMs offer lower payments and rates during the beginning of your loan term, and since you will likely refinance out of your mortgage before rates rise drastically, you will benefit from lower payments without needing to plan for the adjustments that will occur later in the term of your loan. While we often think we are buying our forever home, that isn’t commonly the case: according the National Association of Realtors (NAR), most homeowners over the last two decades have remained in their home for six to seven years, (although that figure has risen to nine-10 years from 2011- 2016).
On the other hand, if you plan to live in the property for a prolonged period of time without refinancing, a fixed-rate mortgage will protect you from inflating rates (and by extension, higher payments). Since fixed-rate mortgages are locked at a specific interest rate for the life of the loan, they offer the stability to plan & budget more easily alongside easier to understand loan conditions.
The current mortgage market – as well as the direction experts believe it’s heading – will also be a deciding factor when you select a loan program. In a market where rates are high and likely to decrease, an ARM will allow you to get the lowest rate possible while also enjoying the benefits of falling rates without needing to refinance. If rates are low and likely to increase (which, according to experts, is the case currently), a fixed-rate mortgage will preserve your payment amount and make budgeting far more predictable. However, should rates fall, borrowers with this loan type will need to refinance to take advantage of those changes—which means paying closing costs and engaging in the loan process again.
Unlike a fixed-rate mortgage, an ARM will have changing annual payment amounts after an initial introductory period. In common hybrid ARMs, borrowers typically choose mortgages with interest rates that remain the same for an introductory period of 3, 5, 7, or 10 years. Each year following the introductory period of a mortgage, those rates then adjust according to the terms of your loan and the current market conditions.
If you know to a great degree of certainty that you will be earning more in three to 10 years, it may reduce the level of risk associated with ARMs. The three to 10-year timeframe is important because from 2003-2014, most homeowners remained in their homes for an average of only 8 years, according to NAR. When homebuyers take out an ARM with the intention of keeping it for the entire loan term, they enjoy a discounted rate initially, but run the risk of paying a higher interest rate when their loan adjusts. Of course, that is not always the case. In recent years, many ARM adjustments resulted in the same or lower rates. Without the funds to cover the worst-case scenario, however, borrowers may be more inclined to take out a fixed-rate mortgage.
Savvy borrowers may take out an ARM to set aside a portion of the savings from lower monthly payments and invest the money elsewhere. The best case scenario for this tactic is that you pay lower monthly payments on your mortgage, your adjusted interest rate doesn’t rise significantly after your introductory period, and you grow your net worth in the process. On the other hand, should your adjusted interest rate rise significantly, you may be able to cover the cost of the increased payments by cashing in on investments, and then refinance with little financial loss.
There you have it! Five questions to ponder when choosing between a fixed rate mortgage or an adjustable rate mortgage. Craving more information on what you should consider during the loan process? Don’t miss our 10 essential questions when applying for a mortgage blog!