Unlike a quality baseball cap, mortgages are not “one size fits all". Lenders offer a variety of loan products, complete with seemingly complicated terminology and financial mechanisms. Lucky for you, there’s a way to find out what kind of mortgage is best for you. Mortgages boil down to two basic categories: adjustable-rate and fixed-rate. Knowing the difference can help you make better financial decisions when buying a home.
How Are Mortgage Interest Rates Determined?
With an adjustable-rate mortgage (or "ARM"), the interest rate on your loan is regularly readjusted. Lenders base this rate on the credit markets, meaning that your interest rate will fluctuate according to market rates. There are a few terms you should know when looking into an ARM:
As the name implies, this refers to the first interest rate the lender gives you when you take out an adjustable-rate loan. Initial rates for ARMs are often relatively low, which appeals to many homebuyers. However, if rates go up, you could end up with a higher interest rate than you would have with a fixed-rate mortgage.
The adjustment period is the length of time your interest rate stays the same before it is reviewed and modified again. Adjustment periods are usually given in a two number format, like 3/1. The first number is the initial adjustment period, and the second number is the length of the adjustment period after that point. So, the initial interest rate would remain fixed for three years, and the lender would then reset the rate annually after that, depending on how the market fluctuates. Some lenders use a different format, so make sure you clarify the adjustment period with your loan officer.
Most lenders place limits on how much they can change your interest rate or your monthly payment at the end of each adjustment period or over the life of the loan. This mitigates you from some of the additional risks you take with an ARM.
Benefits and risks
Lower initial interest rates—and by extension, lower initial monthly payments—often entice homebuyers to secure an adjustable-rate mortgage. However, the lower rates and payments come at the cost of assuming some of the lender’s risk. By opening your interest rate to the possibility of adjustment, you open yourself to the risk of your mortgage rate increasing and your monthly mortgage payments becoming unsustainable. That said, if the rates based on the credit market index stay low, you stand to save more money over time than you would with a fixed-rate mortgage.
4 Common Questions About Interest Rate
With a fixed-rate mortgage, the interest rate given to you by the lender remains the same for the life of the loan. In addition, they benefit from the stability of a monthly payment that does not fluctuate as it would with an ARM. However, a fixed-rate mortgage will initially be more expensive than an ARM, as fixed interest rates are almost always higher. If market interest rates do not rise—or if they decrease—a fixed-rate mortgage will cost more than an ARM.
Which One Is for You?
That depends. If you prefer a more stable, budget-friendly loan, then a fixed-rate mortgage is probably for you. Your monthly payment and rate will not change. If you can afford to assume more risk, and ARM could pay off. Check the rate caps, and if you can still afford the monthly payments at the highest rates, then an ARM could help you save money in the long run. By doing a little homework, you can choose the mortgage that’s right for you.
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