One of the first questions that comes up when making the decision to purchase or refinance a home is, “What type of loan program should I get?” Here’s a tip on choosing between an adjustable or fixed rate mortgage.
Adjustable vs. Fixed Rate Mortgages:
Which Loan Program is Right for You?
An Adjustable Rate Mortgage (ARM) is a loan that starts out with a low introductory rate, but the interest rate will change over time. To give a quick example, a 30-year 3/1 ARM has a set interest rate for the first three years. After that, the interest rate adjusts annually for the next 27 years.
Conversely, a 30-year Fixed Rate Mortgage has the same predictable interest rate throughout the entire life of the loan. This offers the security of knowing exactly what your monthly mortgage payment will be, from start to finish.
An ARM has four components, including the index, margin, interest rate cap structure, and the initial interest rate period.
• Index: The index is an economic indicator that establishes the base percentage rate on your ARM. Though there are many types of indices on the market, the ones most commonly used are the Constant Maturity Treasury (CMT), the 11th District Cost of Funds Index (COFI), the London Inter Bank Offering Rates (LIBOR), or the T-Bill (US Treasury Bill). These indices are published daily and are easy to find in newspapers or on the Internet.
• Margin: While the index is a variable that constantly changes, the margin is a set percentage added on by the lender, which is disclosed in your loan contract. You’ll want to try to get the lowest margin possible on an ARM, because the index and margin are added together to determine the fully indexed rate.
For example, if the current index is 1% and your margin is 3%, then the fully indexed rate is 4%. However, if the index goes up to 4% and your margin is 3%, the fully indexed rate jumps up to 7%. This can have a significant impact on your monthly payment.
• Cap structure: This provides some control over how much your interest rate can go up or down, by setting a “cap” on interest rate adjustments. Typically, there will be an initial, periodic and lifetime cap structure.
• Initial Interest Rate Period: This is usually an attractive low introductory rate, which expires within a set period of time.
While the low-cost introductory rate of an ARM may be enticing, interest rates are constantly changing and a certain amount of risk comes with an adjustable loan.
If you’re only planning to live in the home for a few years, you may want to take advantage of that initial low rate. Another benefit of an ARM is that if rates go down, your mortgage payments may also go down, without having to refinance the loan. However, when rates go up, you also need to consider whether or not you can manage the increase in your monthly payment.
If you’re looking for stability and plan to stay in your home for the long haul, a Fixed Rate Mortgage may be more appropriate for you. But, if interest rates go down significantly, the only way you can take advantage of lower rates is to refinance.
The questions to ask are:
• How long do you plan on living in the home?
• Can you handle the fluctuation of your monthly payments from one year to the next, or do you want something stable?
• What would the maximum interest rate be on an ARM program, and would you be able to make the monthly payment when rates go up?
The truth is, every borrower has different needs, along with unique short- and long-term goals. My team and I work toward finding the loan program that’s right for you. Give me a call if you have any questions! I’m here to help.