If you’re looking to buy a home, you’ve likely come across these two terms, fixed-rate and adjustable-rate mortgages. These terms refer to what happens to the interest rate over time on a home loan, which you’ll have to take unless you are buying your home all-cash. In order for you to make an informed decision on which type of mortgage is best suited for you, we’ve broken down these two options. Let’s dive in!
The monthly total cost of ownership includes 4 main components, principal, interest, taxes, and insurance – referred to as PITI. The type of mortgage you choose will determine whether the amount you pay in principal and interest remains the same over the lifetime of the loan or if it fluctuates.
A fixed-rate loan is a loan that has a set interest rate. The interest rate will not change from the day you take out the loan until the day you make the final payment. While the interest rate doesn’t change, your total monthly payments (PITI) can change over time due to changes in property tax or homeowners’ insurance.
The biggest comfort a fixed-rate mortgage offers is predictability. In general, macro-economic factors and federal fiscal policies affect mortgage rates. However, in a fixed-interest mortgage, your interest rate and hence, your monthly principal and interest payment will remain the same. This predictability also makes it easier for you to budget.
What are some reasons you might decide against a fixed-rate mortgage? While you are protected if the interest rates go up, if the interest rates fall, your payments won’t decrease. In fact, if the interest rate were to go down, you would have to refinance your home to take advantage of the situation. The cost of refinancing your home is very similar to the cost of taking on a mortgage the first time and the process is no easier either.
Because of this, if the interest rate drops and you don’t want to go through the process of refinancing, you could ultimately end up paying more money over the lifetime of the loan than you actually need to.
Adjustable-Rate Mortgages (ARM)
An adjustable-rate mortgage is a loan in which the interest rate can change over time, which can make your payments go both up or down. There is a fixed-rate period that may last 3, 5, or 7 years and then the variable-rate period kicks in. In the variable-rate period, the interest rate typically changes every year. These are called the 3/1, 5/1, or 7/1-ARMs where the 3, 5, and 7 refer to the fixed-rate period and the 1 refers to how frequently the interest rate will change.
In the variable-rate period, the interest rate change is linked to an index. The loan paperwork defines which index your loan is connected to and there are caps on how much the interest rate can change from one year to the next and how big the difference can be between the minimum and maximum rates.
What’s nice about the adjustable-rate mortgage is that, were the interest rate to decrease, you would be paying less. However, if the interest rate rises, you will be asked to pay more – something that wouldn’t happen if you had a fixed-rate mortgage.
How do I Choose?
So, how do you choose between the two options? In order to adequately answer this question, there are a few things to consider:
1. How long you plan to remain in the home?
2. What are the caps on interest rate changes between consecutive years and on the maximum allowed change over the lifetime of the loan?
3. Can you afford payments if the interest rate were to rise to high levels?
How long you plan to stay in a home will help with making the trade-off between predictability in the long term and lower expenditure in the short term. The interest rate during the fixed-rate period of an ARM is typically lower than that of a fixed-rate mortgage. So for first-time home buyers, ARMs are a better option if they plan to stay in their starter home for no more than 7 years.
The caps on the rate changes over consecutive years and over the lifetime of the loan are important factors to consider since they are tied to one’s risk appetite and ability to afford high monthly payment if the situation demands.
How About Alternatives?
To get the best interest rates either on fixed-rate as well as adjustable-rate mortgages, one needs to put in a large down payment, at least 20%, and have a very desirable credit risk profile. For a good number of first-time millennial homebuyers, locking up their life savings in a down payment may not be an option.
At ZeroDown, we offer a new pathway to homeownership – an alternative to a traditional mortgage (fixed- or adjustable-rate). In ZeroDown’s rent-to-own model, occupants of the house build up credits or options that can be applied to the purchase of that home, which operates like a down payment and helps them eventually buy the home they are renting. If you’re interested in seeing what your buying power is with ZeroDown, check out our calculator. You can then go on to explore homes you qualify for on ZeroDown home search.