If you’ve never bought a home before, the whole process can seem a little confusing. One of the first things you have to figure out is whether you should get a fixed-rate or adjustable-rate mortgage. Most people choose the fixed-rate mortgage without even thinking about it, but there are situations where an adjustable-rate mortgage may be a better fit.
How fixed-rate mortgages work
Every mortgage charges interest in order to make the deal worth it for lenders. With fixed-rate mortgages, you lock in a single interest rate for the lifetime of your loan. Usually, the payment period is 30 years, but it can be 20 or 15 if you want to pay off your home more quickly.
The reason fixed-rate mortgages are so popular is that they’re more stable. You know exactly how much money to set aside out of your paycheck each month to cover the bill. In case of a rise in interest rates, you don’t have to worry about a change in your monthly mortgage payment.
How adjustable-rate mortgages work
As the name suggest, adjustable-rate mortgages (ARMs) have interest rates that change over the lifetime of the loan. Most ARMs these days are hybrids, which means they have an initial fixed-rated period, after which the interest rate begins to change, usually once per year. You may see this written as 5/1 or 7/1. This means that you get five or seven years of a fixed interest rate, and after that, the interest rate — and your payments — will be adjusted every year.
The risks of ARMs are obvious. When your interest rate changes, it’s possible that your payments could become unaffordable. If your monthly payments during the initial fixed-rate period would put a strain on your budget, an ARM isn’t a good choice for you. Before taking out an ARM, be sure to get a Truth in Lending disclosure from your lender, which should list the maximum amount your monthly mortgage payment could reach. Make sure you’re comfortable with this amount before you sign on the dotted line.
But there can be times when an ARM is the better choice. Starting interest rates on ARMs are usually lower than on fixed-rate mortgages, so your monthly payments will likely be lower for at least a few years.
If you do not plan to live in the property for an extended period I.E., less than 5 years, a 5/1 arm would be beneficial. Another example is if you have blemishes in your credit that you lan to have repaired or removed. You can use the ARM period to tke advantage of the lower rates and subsequent low payments.
To put this in perspective, let’s say you buy a $250,000 home with a 30-year 5/1 ARM, a 4% initial interest rate, and 20% down. Your initial monthly payment would be $955. In an ideal world, that number wouldn’t increase over the lifetime of the loan, and you’d get the whole house for about $344,000, factoring in interest.