Fixed Or Variable-Rate Mortgage: Which Is Better Now?
For the week ending March 25, 2011, Bankrate.com reported that national average mortgage rates were 4.79% for a 30-year fixed and 3.41% for a 5/1 ARM. To put these rates in perspective, the monthly principal and interest payments for each on a $200,000 mortgage would be $1,048.12 and $888.07, respectively. The ARM costs $160.05 less per month for 60 months, an initial savings of $9,603. Or, if you can afford, say, $1,048.12 per month, you could use that same ARM to qualify for a larger mortgage - about $36,000 larger. (This may be the biggest debt you'll ever incur. Learn why you should retire it sooner rather than later. Check out Paying Off Your Mortgage.)
TUTORIAL: Mortgage Basics
Whether a fixed-rate mortgage or an ARM is the best choice in today's market really depends on your unique situation as a borrower. First, you should talk to several lenders to find out what you actually qualify for given your credit score, income, down payment and other factors. It's far more helpful to know what you're actually working with than to choose among options that are purely theoretical. If you have a choice between a fixed-rate mortgage and an ARM, how do you decide? Consider these factors.
Type of ARM
ARMs come in many types. A 5/1 ARM, for example, has a fixed interest rate for the first five years, then has an interest rate that adjusts once a year for the rest of the loan (say, 25 years). There are ARMs with introductory periods as short as one year and as long as 10 years. There are even ARMs that adjust less-often than once a year but these can be hard to come by. The most widely available option is the 5/1 ARM, followed by the 3/1 ARM. The longer the initial period, the smaller the difference will be between the interest rate of the ARM and the interest rate of the fixed-rate mortgage. Which brings us to our next point.
Payment Difference
Our example above assumes a $200,000 mortgage. If you're taking out a smaller mortgage - say, $100,000 - the monthly payment difference between the ARM and the fixed-rate mortgage shrinks to just $80. This difference may not be large enough to take on the additional risks associated with ARMs (which we'll discuss in a moment). It depends on your financial situation, of course, but if $80 a month is a big deal to you, you might want to ask yourself if you will really be able to afford all the expenses associated with home ownership.
If you want to use an ARM to purchase a more expensive property, you have to consider whether the difference in the quality of property you can get with the ARM makes the interest-rate risk worthwhile. You're going to be tempted to say, "Yes! Of course!," because of the amazing school district/new cherry hardwood floors/wonderful neighborhood, but try to envision how you would feel about that property if the monthly payment doubled in five years.
Risk Tolerance and Future Plans
ARMs are subject to something called interest-rate risk. After the initial term, the interest rate for this type of mortgage adjusts to reflect current market conditions. What will the ARM's interest rate be when it resets after the introductory period? Nobody knows, and therein lies the risk of taking out an ARM.
People who get ARMs often think that one of the following events will occur:
FHA ARMs
If the ARM appeals to you but you're concerned about the risks, consider the FHA's 5/1 ARM. The good thing about an FHA ARM is that it is highly regulated, so you should be able to determine exactly what you are getting into ahead of time. For example, this ARM has a maximum lifetime cap of 5%, which means that the interest rate cannot increase by more than 5% over the 30-year life of the loan. Is 5% a lot? That depends on the amount of your mortgage and how much extra money you have each month that you could put toward a mortgage payment if you had to. Also, FHA loans are often the only option for less-than-ideal borrowers, such as those with less-than-excellent credit and/or low down payments.
The bad thing about an FHA ARM is that, like all FHA mortgages, it requires borrowers to pay an upfront mortgage insurance premium of 1% of the loan amount (which is usually rolled into the loan). It also requires a monthly mortgage insurance premium payment of 0.9% for at least 5 years or until the loan-to-value ratio of the home reaches 78%. These costs increase the expense of owning a home in both the short and long term. (Exotic mortgages allow you to decide how much to pay. Find out how much they really cost. Check out Choose Your Monthly Mortgage Payments.)
The Bottom Line
Only 7% of borrowers these days are choosing ARMs for home purchases according to Freddie Mac's 27th Annual ARM Survey, released in January. If you want to consider joining them, online calculators such as Bankrate's ARM or fixed-rate calculator can perform some of the mathematical calculations that you'll need to make your decision.
TUTORIAL: Mortgage Basics
Whether a fixed-rate mortgage or an ARM is the best choice in today's market really depends on your unique situation as a borrower. First, you should talk to several lenders to find out what you actually qualify for given your credit score, income, down payment and other factors. It's far more helpful to know what you're actually working with than to choose among options that are purely theoretical. If you have a choice between a fixed-rate mortgage and an ARM, how do you decide? Consider these factors.
Type of ARM
ARMs come in many types. A 5/1 ARM, for example, has a fixed interest rate for the first five years, then has an interest rate that adjusts once a year for the rest of the loan (say, 25 years). There are ARMs with introductory periods as short as one year and as long as 10 years. There are even ARMs that adjust less-often than once a year but these can be hard to come by. The most widely available option is the 5/1 ARM, followed by the 3/1 ARM. The longer the initial period, the smaller the difference will be between the interest rate of the ARM and the interest rate of the fixed-rate mortgage. Which brings us to our next point.
Payment Difference
Our example above assumes a $200,000 mortgage. If you're taking out a smaller mortgage - say, $100,000 - the monthly payment difference between the ARM and the fixed-rate mortgage shrinks to just $80. This difference may not be large enough to take on the additional risks associated with ARMs (which we'll discuss in a moment). It depends on your financial situation, of course, but if $80 a month is a big deal to you, you might want to ask yourself if you will really be able to afford all the expenses associated with home ownership.
If you want to use an ARM to purchase a more expensive property, you have to consider whether the difference in the quality of property you can get with the ARM makes the interest-rate risk worthwhile. You're going to be tempted to say, "Yes! Of course!," because of the amazing school district/new cherry hardwood floors/wonderful neighborhood, but try to envision how you would feel about that property if the monthly payment doubled in five years.
Risk Tolerance and Future Plans
ARMs are subject to something called interest-rate risk. After the initial term, the interest rate for this type of mortgage adjusts to reflect current market conditions. What will the ARM's interest rate be when it resets after the introductory period? Nobody knows, and therein lies the risk of taking out an ARM.
- They will sell the home before the loan resets.
- Their income will increase before the loan resets.
- They'll be able to refinance before the loan resets.
- Interest rates will remain stable or decline, giving them a similar rate to the introductory rate when the loan resets.
FHA ARMs
If the ARM appeals to you but you're concerned about the risks, consider the FHA's 5/1 ARM. The good thing about an FHA ARM is that it is highly regulated, so you should be able to determine exactly what you are getting into ahead of time. For example, this ARM has a maximum lifetime cap of 5%, which means that the interest rate cannot increase by more than 5% over the 30-year life of the loan. Is 5% a lot? That depends on the amount of your mortgage and how much extra money you have each month that you could put toward a mortgage payment if you had to. Also, FHA loans are often the only option for less-than-ideal borrowers, such as those with less-than-excellent credit and/or low down payments.
The bad thing about an FHA ARM is that, like all FHA mortgages, it requires borrowers to pay an upfront mortgage insurance premium of 1% of the loan amount (which is usually rolled into the loan). It also requires a monthly mortgage insurance premium payment of 0.9% for at least 5 years or until the loan-to-value ratio of the home reaches 78%. These costs increase the expense of owning a home in both the short and long term. (Exotic mortgages allow you to decide how much to pay. Find out how much they really cost. Check out Choose Your Monthly Mortgage Payments.)
The Bottom Line
Only 7% of borrowers these days are choosing ARMs for home purchases according to Freddie Mac's 27th Annual ARM Survey, released in January. If you want to consider joining them, online calculators such as Bankrate's ARM or fixed-rate calculator can perform some of the mathematical calculations that you'll need to make your decision.
by
Amy Fontinelle
Amy Fontinelle is a financial journalist and editor for a variety of websites, public policy organizations, and book publishers. She has written hundreds of published articles and blog posts on topics including budgeting, credit management, real estate and investing. Her articles have been featured on the homepage of Yahoo! and on Yahoo! Finance, Forbes.com, SFGate.com and numerous local news websites.
Free Annual Reports
