Comparison of ARMs and Fixed Rate Mortgages
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Choosing a mortgage is complicated. One of the first choices you will make is also one of the most important: fixed rate or adjustable rate?
Your decision will affect not only your monthly payment, but also how long it takes to pay off your mortgage and how much interest you pay along the way.
An adjustable rate mortgage, or ARM, may be a better choice in very specific circumstances, but with interest rates at record highs this year, a fixed rate mortgage is clearly the winner for most borrowers. at the moment.
The percentage of ARM applications has fallen by 50% since late March 2020 and accounted for 3% of all residential mortgage applications, according to data from the Mortgage Bankers Association.
Differences between fixed rate and variable rate mortgages
The most important difference between fixed rate mortgages and ARMs is simple. A fixed rate mortgage has an interest rate that does not change. The interest rate on a variable rate mortgage changes at predetermined times, up to the limits shown in the fine print of the loan.
The rate of an ARM will be reset on different timeframes depending on the loan. The interest rate adjustment schedule is presented as a fraction. The first number in the fraction is the initial rate reset and the second is how often it changes after the first adjustment. So an ARM 5/1 has a fixed rate for five years, and then the rate adjusts each year thereafter. Typically, an ARM is a 30-year mortgage.
A fixed rate mortgage is simpler than its variable rate counterpart. The main difference that you will find with fixed rate loans is in the amortization schedule or the terms of the loan. Just like with ARMs, there are 30-year fixed rate mortgages. But you can also choose shorter terms, like 10 years or 15 years.
With a fixed rate mortgage, you can opt for shorter terms. You will have a larger monthly payment, you will pay off your mortgage much faster.
Why MRAs don’t make sense now
Choosing between an ARM and a fixed rate mortgage is a matter of risk versus reward. With a fixed rate mortgage, the borrower locks in a rate for the term of the mortgage. With an adjustable rate, the borrower takes the risk of seeing his rate increase in the future. In exchange for the increased risk, the borrower usually gets a lower starting interest rate.
Right now, the difference between the starting rates for adjustable mortgages is minimal to no compared to a fixed rate loan, says Greg McBride, chief financial analyst at Bankrate.com. “If you don’t get any benefits, but you still take on the same level of risk, why bother?”
The current economic outlook only adds to the waning appeal of ARM. One situation where ARMs have traditionally made sense is when you plan to sell the property before the rate is reset. This strategy is based on rising house prices or at least on stability.
While house prices have risen in many areas, due to historically low mortgage rates and low home inventories, no one can guarantee this will continue in the long term. After all, in January 2020, how many experts predicted a trillion dollar decline in the global economy? And with unemployment still in double digits and COVID-19 still on the rise as the summer ends in many parts of America, it’s important to forecast future uncertainty.
After declining steadily since the 1980s, mortgage rates do not have much leeway to go down. So if you are able to afford a house or refinance, locking in on a fixed rate is the way to go.
Plus, with a fixed rate mortgage, you have the option of choosing a shorter repayment term, such as a 15-year loan. Compared to a 30-year mortgage, a 15-year home loan will have a lower interest rate, but higher monthly payments. You can potentially pay more per month, but borrowers are willing to do it in order to pay off debt faster and save thousands of dollars in interest payments over the life of the loan, says Mortgage Specialist Nadia Alcide at Mortgage Biz of Florida. . And the option of taking out a short-term mortgage is not usually available with an ARM.
What needs to be changed for an ARM to make sense?
For ARMs to make more sense to people, the spread between fixed rate and variable rate mortgages would have to increase, which is more likely to happen when interest rates rise globally.
In any event, ARMs will still only make sense to a small subset for homebuyers and those looking to refinance. Here are some situations where an ARM may make sense, if it represents a significant saving compared to a fixed rate loan.
You are definitely not keeping the loan for the long term
Many people’s careers allow them to wait and plan to move from time to time. For people in this position, an ARM might be a cheaper option than a fixed rate mortgage. Especially if you know you will need to move within the next 5-10 years.
But even then, you’ll want to run the numbers. With an ARM, you are still responsible for closing costs. Closing costs can be anywhere from 2% to 6% of the loan amount, and for an average house of several thousand dollars, you will pay up front. If you only stay in the house for a year or two, it may be cheaper to rent than to buy with any type of mortgage.
You can put the extra savings to work for you
When an ARM’s monthly savings are significant, you may be able to put the extra savings to good use.
The introductory period of a variable rate mortgage – when the rate is at its lowest – can be an opportunity to increase your retirement savings or build up your emergency fund. You can also take the money you save and pay back your principal.
If you plan to pay off your mortgage in 10 years, an ARM with a 10-year introductory rate might help you do it more easily. The extra equity you build can make it easier for you to refinance or save money by giving up your private mortgage insurance obligation sooner.
There is a caveat to this approach: you have to be in a situation where if your rate goes up, you can afford it. You can plan for this up front, as an ARM has limits on how the rate can increase, all at once or over the life of the loan. If at some point you are considering an ARM, be sure to ask your lender about these limits.
You take out a jumbo loan
Jumbo loans are non-conforming loans because they exceed the dollar amount set by Fannie Mae and Freddie Mac. For 2020, the limit is $ 510,400 for most of the country, but it can be up to 150% higher in areas where homes are more expensive.
Because jumbo loans are not guaranteed by the government, they are riskier for lenders and have more stringent underwriting guidelines. This is why jumbo loans also have higher interest rates than conforming loans.
Due to these higher rates, the spread between jumbo ARMs and fixed rate loans can be larger than with compliant loans. So you might save more during the introductory period, but jumbo loans are, by definition, bigger loans. So any future price increases on a jumbo arm will have a bigger impact on your monthly budget.
Your income will increase
There are situations where an ARM may make sense for high net worth or higher income households, McBride says. If you’re expecting a big increase in your income, an ARM might be right for you. A doctor who completes his residency is a good example of someone to whom this applies.
Paying less than an adjustable rate can provide flexibility if your income is variable or seasonal, he says. But again, he stressed that it only works in extreme cases, for example athletes or artists.