What is the difference between fixed and adjusted rates? Which is better? Which one should you get? Which will help me get my San Diego dream home? Each with have their own advantages and disadvantages, Greater Home Loans breaks down the basics; read on to find out which suits you!
Fixed Rate Mortgage:
If you have a fixed mortgage rate then your mortgage payment each month is set when you take out the mortgage.
The most common terms for fixed rate mortgages are 15, 20, or 30 years. This means that you are making the same payment on your home for 30 years or until it is payed off.
Who fixed rates appeal to:
- Those who are looking to buy and stay in a house for a long time
- Those who want want consistency with their mortgage payments
- Those who are looking for simplicity and do not want to have to worry about changing rates and caps
What to be wary about:
- The longer the loan could mean the more you may pay overall because you may have to pay more interest over time.
- While you do have the option to refinance your loan (for example when you took out the loan the rates were high and since then the rates have dropped significantly). This can potentially lead to thousands of dollars in external costs so be sure to weigh the advantages and disadvantages.
Adjusted Rates Mortgage:
For adjusted rate mortgages (ARM) what you pay each month can change based on what the interest rate is.
There are also different types of for ARMs. It is very favorable to get a hybrid ARM which combines both adjusted rates and fixed rates. The most popular type being the 5/1 ARM as well as the 3/1, 7/1, and 10/1. How a hybrid arm works is that you pay a fixed rate for the first part of the terms (for a 5/1 that is 5 years) and then for the remainder of the loan term your loan is adjusted every year. For individuals in the US, most of their interest rates are based on the U.S. Treasury.
While ARMs adjust based on the interest rate set up by the US Treasury (most common as there are other indices used) there is still limits on how much that your rate can adjust. These limits are known as caps and come in different forms:
- Periodic Rate Cap – limits how much your interest rate can change each year
- Lifetime rate Cap – limits how much your interest rate can change over the lifetime of the loan
Caps can be broken down into 3 parts. Let’s look at the 2-2-5 cap structure as an example:
- The First 2 – The initial adjustment cap – The first year after the introductory (or fixed rate period) expires the
- The Second 2 – The subsequent adjustment cap – Each year after the first year your rate can increase by 2%
- The 5 – Lifetime adjustment cap – Your total interest rate will never increase by more than 5%
Who ARMs appeal to:
- Those who want to keep their future open
- Those who want a lower initial payment
- For those who do not qualify for a fixed rate
- Those who want to take advantage of falling rates (but are also subject to the rate spikes)
- Those who do not want to worry about refinancing
What to be wary about:
- Different lenders might offer the same initial interest rates but with different rate caps, look to see which rate cap suits you
- Because you can take advantage of the falling rates that also means that you are subject when rates rise. While you still have a cap, your interest rate can start at 3% but with a 5% lifetime adjustment cap it can still potentially jump up to 8%.
- Because your rate can change frequently over the life of the loan, it can be difficult to budget for.
- Because interest rates right now are low they are likely to go up so an ARM might be a risky option.
Hopefully you found this article as interesting as I did!