Which is the better mortgage option for you: fixed or adjustable?
The low initial cost of adjustable-rate mortgages (ARMs) can be very tempting to home buyers, yet they carry a great deal of uncertainty. Fixed-rate mortgages (FRM) offer rate and payment security, but they can be more expensive.
Here are some pros and cons of ARMs and FRMs.
ARM advantages
Feature lower rates and payments early on in the loan term. Because lenders can use the lower payment when qualifying borrowers, borrowers can purchase larger homes than they otherwise could buy.
Allow borrowers to take advantage of falling rates without refinancing. Instead of having to pay a whole new set of closing costs and fees, ARM borrowers just sit back and watch their rates fall.
Help borrowers save and invest more money. Someone who has a payment that’s $100 less with an ARM than with a FRM for a couple of years can save that money and earn more off it in a higher-yielding investment.
Offer a cheap way for borrowers who don’t plan on living in one place for very long to buy a house.
ARM disadvantages
Rates and payments can rise significantly over the life of the loan. A 6 percent ARM can end up at 11 percent in just three years if rates rise.
A borrower’s initial low rate will adjust to a level higher than the going fixed-rate level in almost every case even if rates in the economy as a whole don’t change. That’s because ARMs have initial fixed rates that are set artificially low.
The first adjustment can be a doozy because some annual caps don’t apply to the initial change. Someone with an annual cap of 2 percent and a lifetime cap of 6 percent could theoretically see the rate shoot from 6 percent to 12 percent 12 months after closing if rates in the overall economy skyrocket.
ARMs are difficult to understand. Lenders have much more flexibility when determining margins, caps, adjustment indexes and other things, so unsophisticated borrowers can easily get confused or trapped by shady mortgage companies.
On certain ARMs, called negative amortization loans, borrowers can end up owing more money than they did at closing. That’s because the payments on these loans are set so low (to make the loans even more affordable) they only cover part of the interest due. Any additional amount due gets rolled into the principal balance.
