If you’re planning to buy a house, one of the most important decisions you will make is whether to get a fixed-rate or adjustable-rate mortgage. Make sure you understand how both work and consider your current circumstances and future plans before choosing.
With a fixed-rate mortgage, the interest rate remains constant over the life of the loan. An adjustable rate mortgage (ARM) has an introductory rate that is below the market rate for a fixed-rate mortgage. After one or several years, the rate begins to reset periodically based on market conditions. An ARM may have caps to limit the amount the interest rate can increase at once, a ceiling on the interest rate and a cap on monthly payments.
Pros and Cons
A fixed rate-mortgage could allow you to have consistent monthly payments. An ARM might be much less expensive than a fixed-rate mortgage in the period before the loan reset. Those lower initial payments might make it possible for you to afford a more expensive house with an ARM than you could with a fixed-rate loan.
The danger of an ARM is the unpredictability. Your monthly payments could rise significantly several times over the life of the loan. If you chose an ARM and the interest rate rose, you might be able to refinance to another ARM or to a fixed-rate loan, but there would be no guarantee. A lender would consider your income at the time, the amount of equity and other factors, as well as the overall state of the economy. Even if you were able to refinance to a lower rate, you would have to pay closing costs.
Which Is Right for You?
ARMs tend to appeal to first-time homebuyers who expect their incomes to rise in the future or who plan to have children and move in a few years. If you expect your income to increase as you move up the ranks in your company, or if you plan to earn a degree and get a better job, an ARM could be a good bet. You could have low payments now, pay more in the future when you have a higher income and pay less over the life of the mortgage than you would with a fixed-rate loan.
Consider your financial circumstances, including your income and how much you expect to earn in the future, as well as how long you plan to live in the house. If you would be able to afford higher payments later, or if you plan to move before the interest rate would reset, an ARM could save you money. If you plan to stay in the house longer, a fixed rate could give you peace of mind.
Look at the specific terms of different loan options. If you are considering an ARM, figure out how much your monthly payments would be in a worst-case scenario. If you couldn’t afford that amount, a fixed-rate mortgage could be a safer option, even if it might cost you more at first.