Are you ready to buy a home?
If you’ve decided that homeownership is your next big step, one of the most important things you’ll need to do is secure a mortgage.
You’ll also need to decide whether a fixed-rate mortgage or an adjustable-rate mortgage (ARM) is right for you.
Here’s what you need to know about both types of mortgages as you make your decision:
Fixed-rate vs. variable-rate mortgage: what’s the difference?
Each type of mortgage has its pros and cons, so it’s important to understand the implications and differences before you make a decision.
When you get a mortgage with a fixed rate, you don’t have to worry about the interest rate changing during the life of the loan. It remains the same no matter what happens with the economy.
That means that even if interest rates rise three or four percent, you still keep the same rate you got at the beginning of the loan.
When you have an ARM, or a variable-rate mortgage your interest rate can adjust with market conditions. So as interest rates rise, so does the cost of your payments. On the flip side, when interest rates fall, you don’t have to pay as much each month.
Pros and cons of a fixed-rate mortgage
The biggest advantage to a fixed-rate mortgage is that you lock in your rate. And if you do so when rates are low, you can save a lot of money over the life of your mortgage. You also don’t have to worry about mortgage rate jumps.
Using CalcXML, you can compare a fixed-rate mortgage to an ARM. Let’s say you borrow $200,000 for 30 years and you’re trying to decide between a fixed rate of 4.15% or an adjustable rate of 3.50%.
Assuming interest rates rise in the future, you can see that you’re better off in the long run getting a fixed-rate mortgage in the image below. That’s because you’ll pay a total lower total amount than with an ARM.
Another advantage to a fixed rate is the fact that you can count on the same payment. So when it comes to budgeting, this makes your life a little easier. You always know exactly how much you will pay for your mortgage.
On the other hand, when you have a fixed rate for your mortgage, you run the risk of missing out on interest rate drops.
Additionally, a fixed rate is often higher than what you will see with an ARM. This can mean your mortgage is more expensive initially, that is until interest rates rise to catch up.
Pros and cons of an adjustable-rate mortgage
The main advantage of an ARM is that you can usually get a lower interest rate. It’s not uncommon to see a rate that is more than 50 basis points lower when you choose a variable-rate mortgage or ARM.
You also take advantage of falling interest rates. Using the same information from above but assuming decreasing interest rates you can see that the total ARM costs are less over time in the image below using CalcXML.
It’s interesting to note, however, that you see a bigger advantage with a fixed-rate loan, saving more than $100,000 over 30 years. Even with decreasing interest rates, the ARM advantage isn’t as large, amounting to a little over $6,000.
One of the reasons for this is the fact that there’s more room for interest rates to rise right now. We’re in a low-rate environment, so there is only so far that rates can fall.
You also have to worry about changing monthly payments. Your payment could rise, causing a potential strain on your budget. Although many lenders put a cap on how high the rate can go, that still doesn’t change the fact that your payment can go up regularly as rates rise.
If you want to take advantage of a low fixed rate — at least for a little while — you can get a variable-rate mortgage called a hybrid ARM.
This is a mortgage that has a fixed rate for a set period of time before it becomes variable. It’s common to see hybrid ARMs with fixed periods of three, five, and seven years.
The most common hybrid ARM is the 5/1 mortgage. This means that the rate is fixed for the first five years of the mortgage. After that, the rate is reset every year.
A hybrid ARM can work well if you want to get a low rate now and refinance later. You also get to save money during the first part of your mortgage, then hopefully refinance to a lower rate before the rate becomes variable.
Unfortunately, if housing values fall before you can refinance, you might not be able to make it happen. Additionally, if rates go up during your fixed rate period, refinancing means you end up with a higher rate. Depending on the terms of your mortgage, you might be better off keeping the original mortgage instead of refinancing.
Is now the time to get an ARM?
If your main concern right now is saving money on your monthly payment for cash flow reasons, an ARM may make sense.
You just have to be aware that your payment could go up down the road. So between now and then, do what you can to earn more money so you aren’t in financial trouble if the payment goes up.
However, if you are mostly concerned about rising interest rates, now might not be the time to get an ARM. There is speculation that the “Trump effect” could mean inflation — and higher mortgage rates.
Lawrence Yun, the chief economist with the National Association of Realtors, writes in Forbes that he expects interest rates to rise in the coming years. His forecasts rates of between 4.5% and 4.8% by the end of 2017 and 5.5% by the end of 2018.
Unless we see another major economic event in the coming years, higher rates are likely in the cards, which means a fixed-rate mortgage might make more sense. Yun points out that, even though it feels like mortgage rates are high, historically they are still low.
Yun also points out that in the 1970s the average mortgage rate was 8.9%, while in the 1980s the average rate was 12.7%.
Then rates started dropping in the 1990s to average out at 8.1%. Even in the early 2000s, mortgage rates were right around 6.3%. Yun says the current rates seem high because we’ve had even lower rates in the last couple of years.
Know your market
Before making a decision about your mortgage, make sure to do your homework. Research your market and pay attention to the economic climate.
And remember, the type of mortgage that makes sense for you depends on where you live, your current financial situation, and what happens next with the economy.