Fixed Rate vs. Adjustable Rate Mortgages (ARMs)
Mortgage rates are changing every day. This year has been amazing for mortgage rates – some are under 3% right now, some of the lowest rates in history. If you’ve been looking to get a mortgage recently, you might have seen some charts that list rates for 15, 20, or 30 year fixed rate mortgages and you’re familiar (or not) with those, but then there are things called 5/1 or 7/1 ARMs. What on earth? Let’s find out a little.
Fixed Rate Mortgage
So let’s begin with the simpler type of mortgage – fixed rate. A fixed rate mortgage is pretty much exactly how it sounds – you get pre-approved and close your loan at a specific rate (let’s say 3.15%) and for the life of your loan (15, 20, 30 years) your rate will stay at 3.15%. If the market suddenly tanks and new loans are at 10%, yours still stays at 3.15%. (Downside is if the market becomes insane and the rates drop to 1%, you’re locked in at 3.15% unless you want to refinance but that’s a whole other can of worms).
Adjustable Rate Mortgages (ARMs)
So, if you understood the positives and negatives of the fixed rate (rates could get better or worse than your locked in rate) then you can sort of transfer that to ARMs. Basically, with an ARM, you are locked into a great, low rate (lower than most fixed rate) for the first few years, and then the rest of the years are up to market changes. For example, a 2/28 ARM would be 2 years at a fixed rate, 28 years at a variable rate. A 5/1 ARM would be 5 years at a fixed rate, and then the rate would change each year after.
The benefit to ARMs is that you nail in a low rate for the first few years. If your loan allows, you could overpay each month so that when that first rate is up, you’ve paid more back at a lower rate. For example, say your ARM rate is 2.5% for the first 5 years and your mortgage is $1000 a month. Since your rate is low, you could pay $1400 a month so in 5 years, you’ve paid an additional $24,000 in case your rate then goes up, which it is likely to do. An ARM is often a good idea for someone who is likely to want a shorter loan term or thinks they could pay off their loan before the full amount of time.
The downside to ARMs is while you may get a great rate to begin in those first 2, 5, or 7 years, the rate could jump enough where it negates all those savings from the initial low interest rate. ARMs can be a bit of a gamble.
Overall, the typical buyer (especially first time buyer) is most likely to go with a fixed rate mortgage since there are no surprises down the line. However, that’s easy to say right now since rates are great. If they begin to creep up in the next year, or few years, there could be more appeal to going with an ARM in the hopes you lock in a slightly lower rate at first and maybe, with luck, the rate will go down not up after that time period.
To end on a horrible joke I just thought of…
What do you call the problem of wondering whether to go with an adjustable rate mortgage or not? ARM wrestling.
It’s okay if you want to never read my blog; I’d understand.