Congratulations! There are fewer exciting times in life then deciding to take the plunge into homeownership. However, before the champagne is popped and your milestone toasted, you’ll need to spend some time navigating the confusing waters of home financing and determine the mortgage loan that’s right for you.
Since the type of loan you choose will influence your interest rate, it’s important to have a thorough understanding of your options. While fixed rate mortgages (FRMs) have been the go-to for many Americans over the years, adjustable rate mortgages (ARMs) are rising in popularity and could offer a better option for your personal financial situation.
We’ve put together this short guide covering the basics of fixed rate and adjustable rate mortgages to help get your feet wet when it comes to home financing. Let’s break it down.
Fixed Rate vs. Adjustable Rate Mortgages: The Basics
Fixed rate mortgages and adjustable rate mortgages are the two most popular lending options, each offering their own advantages and disadvantages. Before financing your home, it’s important to have a firm grasp on both to secure the best loan option for your given financial situation.
Fixed Rate Mortgage Loans
Fixed rate mortgages offer a great option for individuals to which long-term stability and predictability are paramount. Aptly named, FRMs have an interest rate that remains the same for the duration of the loan term whether the term be for ten, fifteen or even thirty years. This remains true regardless of economic fluctuations and possible rising lending rates. FRMs are a great option for those ready to lay down roots and stay in one home long term since your locked in mortgage rate will never vary. However, while a great option for those more risk-averse, fixed rate home loans generally come with higher interest rates than adjustable rate mortgages.
Bottom line? If you have a stable career, growing family and are ready to lay down long-term roots, a fixed rate mortgage will avoid you the anxiety of variable interest rates.
Adjustable Rate Mortgages
Contrary to FRMs, as the name suggests, adjustable rate mortgages begin with a fixed interest rate for a specified amount of time, then annually “adjust” in relation to an index. Initial fixed rate periods can vary between three and ten years with your adjustable rate taking over thereafter. While lenders generally charge lower initial interest rates for ARMs then FRMs for the same loan amount, your adjustable rate can fluctuate greatly later in the loan term. This makes an ARM a great option for young buyers and those who value mobility or keeping long-term options open. Additionally, due to a lower initial interest rate and monthly payment, ARMs can qualify buyers for a larger loan amount and lend greater purchasing power when deciding on a home. This is a great solution for people who know they will be receiving raises or bonuses in the near future. For those who can’t afford a particular home at a higher fixed rate, but can with an ARM, they will be able to afford the higher payment once the fixed rate period ends.
Your interest rate on an ARM will be comprised of two parts: the index and the margin. The index is a projected measure of interest rates over time (typically, the LIBOR or Wall Street Journal Index), while the margin is the additional amount or percentage points a lender adds above the index, generally 2.25%. It remains constant throughout the life of your loan.
Concerned about the possibility of infinitely rising interest rates or monthly payments? Don’t fret! The majority of all ARM loans have caps limiting the amount your interest rate can increase during an adjustment period or over the life of the loan. These interest rate caps are known as periodic or annual adjustment caps and lifetime caps, respectively. By law, essentially all ARMs are required to have a lifetime cap. Your annual adjustment cap will typically be limited to a 2% increase or decrease, while your lifetime cap will usually be limited to 5%. For example, if your initial interest rate is 3%, your maximum rate cannot exceed 8%.
Bottom line? If you value relocation flexibility or plan on owning your home for a shorter amount of time then the introductory period of your loan, an adjustable rate mortgage is the right choice. You’ll benefit from a lower initial rate without the financial vulnerability of the adjustable rate period of your loan term. Our rule of thumb? If you’re planning to stay in your home less than ten years, an ARM is the loan for you.
A more in depth look at adjustable rate mortgages and the different types available can be found here.
Still have questions? Contact one of our mortgage loan experts today at (314) 434-7000 or get the ball rolling with this free secure online application!