Fixed Rate vs. Adjustable Rate Mortgages
Whether fixed rate or adjustable (ARM) is better depends on your needs and the current market.
Before choosing a mortgage, you need to understand the differences between mortgage types: fixed rate mortgages, adjustable rate mortgages, and interest-only mortgages, to name a few.
Fixed Rate Mortgages
With a fixed rate mortgage, the interest rate and the amount you pay each month remain the same over the entire mortgage term, traditionally 15 or 30 years. You can use Nolo's fixed rate mortgage calculator to figure out your payment. A number of variations on fixed rate mortgages are available, including five- and seven-year fixed rate loans with balloon payment s at the end. (Nolo also offers a balloon payment calculator.)
Adjustable Rate Mortgages (ARMs)
With an adjustable rate mortgage (ARM), the interest rate fluctuates according to the interest rates in the economy. Initial interest rates of ARMs are typically offered at a discounted ("teaser") interest rate that is lower than the rate for fixed rate mortgages. Over time, when initial discounts are filtered out, ARM rates will fluctuate as general interest rates go up and down.
Different ARMs are tied to different financial indexes, some of which fluctuate up or down more quickly than others. To avoid constant and drastic changes, ARMs typically regulate (cap) how much and how often the interest rate and/or payments can change in a year and over the life of the loan. Use Nolo's adjustable rate mortgage calculator to figure out your payment.
A number of variations are available for adjustable rate mortgages, including hybrids that change from a fixed to an adjustable rate after a period of years, or "option ARMs" that allow you to choose, on a monthly basis, whether to pay a minimum amount, an interest-only amount, an ordinary principal plus interest amount, or an accelerated payment amount.
Interest-Only Loans
A popular option recently has been "interest-only" loans, which allow you to pay only the interest amount each month -- not any principal -- for the first several years of the loan. This can lower your initial monthly payments significantly, allowing you to afford more house. But eventually you'll have to pay off the loan balance, and the shift in monthly payments can be a shocker. Most interest-only loans are adjustable, but it's possible to find fixed rate interest-only loans too.
How to Choose the Best Mortgage
Next comes the question of which is better. Because interest rates and mortgage options change often, your choice should depend on:
- the interest rates and mortgage options available when you're buying a house
- your view of the future (generally, high inflation will mean ARM rates will go up and lower inflation means that they will fall)
- your personal financial and investment goals, and
- how willing you are to take a risk.
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When mortgage rates are low, a fixed rate mortgage is the best bet for many buyers. Over the next five, ten, or thirty years, interest rates are more apt to go up than further down. Even if rates could go a little lower in the short run, an ARMs teaser rate will adjust up soon and you won't gain much if you plan to stay in the house more than a few years (the broker can tell you your break-even point). In the long run, ARMs are likely to go up, meaning many buyers will be best off locking in a favorable fixed rate now and not taking the risk of much higher rates later.
To tie it all together, Nolo's free mortgage comparison calculator allows you to enter the terms (rates, points, closing fees) of up to three different mortgages to compare their value (total payments, taxes saved, and present value).
Refinancing Options
Keep in mind that lenders not only lend money to buy homes; they also lend money to refinance homes. For example, if you take out a fixed rate loan now, and several years from now interest rates have dropped, refinancing will probably be an option.
There are several downsides to refinancing, however. Unless you can negotiate a low-cost refi, you may have to pay the same fees and points as for an original mortgage. This means you may reduce your monthly payment right away but not actually begin to save money on the refi for several years. (You can use Nolo's refinancing calculator to determine when you'll break even.) If you think you'll be moving again soon, a refi may not make sense.
Also, if you default on a refinanced mortgage, your position under your state's law can get worse. In California, for instance, when a homebuyer defaults (stops paying the mortgage), the lender can foreclose on the house but take nothing else from the homebuyer, while on a refinanced mortgage it can go after the homebuyer's cash and other assets, after the house, to satisfy the debt.
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