Should I Choose a Fixed or Adjustable Rate Mortgage?
You’re at a stage in your life where you’re starting to consider purchasing a home. Congratulations! That’s a major milestone in the life of just about anyone. Whether it’s your first home or a second or third, odds are that you won’t be able to afford the purchase with cash alone. You’re almost certainly going to need a mortgage.
If this isn’t your first time at the homeowner rodeo, you’re probably well-acquainted with the various types of mortgages offered by banks and credit unions. If this is your first time buying a home, however, learning the nuances of mortgages can be daunting. At Rivermark Community Credit Union, we aspire to help inform those making major financial choices, so we’d like to answer a very common question: should you choose a fixed or adjustable rate mortgage?
Understanding Mortgage Rates and Payments
“The most powerful force in the universe is compound interest.” – Albert Einstein
Before we look at the specifics of fixed rate and adjustable rate mortgages, it’s important to understand how, exactly, a mortgage gets paid off.
There are two parts to any mortgage payment: the principal, which is the value of the loan itself, and the interest. What you pay depends on the length of your mortgage. Some of the most common and popular loan terms are 15-, 20-, or 30-year repayment periods. Thirty-year mortgages are particularly popular because a longer amount of time means that your month-to-month payments will be lower than a shorter-term mortgage. However, this means that you’ll wind up paying more in total, due to the longer period of time, meaning that the interest rate will have more time to compound itself.
Let’s say your principal is $200,000 and your interest rate is 4%. If you have a 15-year mortgage, you’ll owe about $1,479 every month. Over 180 payments, this means the full price of your home will be $266,220. For a 30-year mortgage, on the other hand, you’ll owe just $955 every month … but with over 360 payments, that results in a total of $343,800.
That number only gets higher if you have higher interest rates. At a 6% interest rate over 30 years, you would wind up paying $431,640 for that same $200,000 home. Whether you have a fixed or adjustable rate mortgage, you can clearly see that higher interest rates can wind up costing you significant amounts of money over time.
(All rates calculated using Calculator Soup.)
How Does a Fixed Rate Mortgage Work?
A fixed rate mortgage is exactly what it sounds like: a mortgage with the interest rate set in stone at the moment the papers are signed. When you get a fixed rate mortgage, you know exactly what your monthly payment will be and exactly what your end cost will be—you can use a handy calculator like the one linked above or Rivermark’s mortgage calculator to know how much, over the coming decades, you need to budget.
The chief advantage of a fixed rate mortgage is its consistency. You know exactly how much you’ll have to pay every month over the life of the loan. This will change very little from lender to lender. However, this is also its downside: if interest rates are high, monthly payments will also be high, and even if interest rates go down, your mortgage will not.
How Does an Adjustable Rate Mortgage Work?
An adjustable rate mortgage (or ARM) is also exactly what it sounds like: a mortgage where the interest rate can change over time.
When you sign an ARM, frequently, the first few years of repayment will be offered at a lower rate than its fixed rate counterpart. However, after that initial set period of time, the ARM will start fluctuating. These fluctuations are typically tied to specific indexes, like the Federal Prime Rate or the London Inter-Bank Offered Rate (LIBOR).
There is usually an added margin on top of this rate, which is how a lender makes money on the loan. For example, the current Prime Rate is 4.75%. If your ARM was pinned to the US Prime Rate with a margin of 2%, your monthly interest would be 6.75%. If the Prime Rate fell to 3%, your mortgage interest would fall to 5%; if it rose to 6%, your mortgage would rise to 8%.
The benefit to an ARM is that, especially in the short-term, the interest rates tend to be lower than a fixed rate mortgage. If the calculating index has a downturn—for instance, as in the time immediately following the 2008 financial crisis—then this lower rate may persist for longer periods of time. If it does, your final payment could be much lower than in a fixed rate mortgage.
The downside, of course, is that an ARM is more difficult to plan for in the long-term. On top of that, an ARM’s interest rate can surpass that of a fixed rate mortgage if rates trend upward.
Should You Choose a Fixed or Adjustable Rate Mortgage?
The answer to this question will largely depend on you, your financial status and the environment in which you are seeking a mortgage. Generally speaking, fixed rate mortgages tend to be more cost-effective in the long run, while adjustable rate mortgages will be easier on your wallet in the short-term.
Here are some situations where an ARM might make more sense than a fixed rate mortgage:
- If you expect to pay the balance quickly. If you anticipate that you’ll be able to pay the principal in full before the rates get too high, an ARM will save you some money. For instance, if you’re selling a home while buying a new one, but won’t have the money until the sale clears, an ARM is a good idea.
- If you expect your income will increase. For people such as business, medical, or legal students who may have lower incomes at the moment but who expect to earn significantly more before too long, an ARM could be an excellent fit. The lower monthly payments early will be easier to absorb, while the higher payments, later on, will make sense given the new levels of income.
- If you don’t plan on living in this home for too long. If you intend for your purchase to only be a temporary home—for instance, if you’ve moved to a new city for school or work—then an ARM may be to your benefit. When you move out and sell the house, you’ll only have had to deal with the lower rates of an ARM.
These are just some of the circumstances in which an adjustable rate mortgage makes more sense. However, if you plan on living in the home for the long haul, and you don’t expect a sudden influx of cash, a fixed rate mortgage may be better than an adjustable rate one.
If you’re interested in learning what sort of mortgage may be right for you, contact the experts at Rivermark Community Credit Union today for a consultation.