You keep reading about them on the business pages and once in a while you’d see statistics talking about mortgage rate movements for fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs). But have you ever stopped to wonder about what differentiates these two products from each other? Read on, and we’ll be glad to talk you through the difference between both mortgage types.
First of all, let’s talk about the basics. As far as fixed-rate mortgages are concerned, the interest rate of your mortgage will remain the same throughout the entire term. When we say “term,” this is the duration of your loan, or as some call it, the LOL – that’s Life of Loan. The rate on your FRM will remain the same unless you refinance, which is always a good idea if interest rates go down substantially at some point during the term.
Adjustable-Rate Mortgage (ARM)
On the other hand, ARMs differ because your interest rate and/or payments can vary depending on the type of product you take out. Typically, ARMs have fixed rates for the first one, three, five, seven, or ten years, with the rates changing once that period is up. The interest rate will change based on an index previously agreed on when you took out your mortgage.
You may also be confused about some of the terms used on ARMs. Take this simple example – a 5/1 adjustable-rate mortgage. The “5” refers to the number of years before your rates change for the first time, while the “1” refers to the interval in which rates would change during the LOL. There’s also another number you have to take note of when looking around for the best rates on ARMs – if you have a 1/5 cap on your ARM, that means the maximum rate increase once the initial fixed rate changes cannot go beyond 1 percent, while the maximum increase during the term is capped at 5 percent.
Should I Choose A Fixed-Rate Or An Adjustable-Rate Mortgage?
Now, that you know the basics of FRMs and ARMs, you may be wondering which is the better product to choose. When deciding on this, many consumers only think about the options that could save them the most money on monthly payments. This is an overly simplistic, and often inaccurate way of going about things. Instead, you’ll want to reduce the interest you pay over the time you expect to stay in the home. This is important, because not everyone will want to stay in the same home for 30 years, even if 30-year FRMs are currently the most popular type of mortgage in the country. So if you’re only planning to stay in the home for five years, you want a mortgage where your rate is fixed for five years, as opposed to one where it stays the same throughout the LOL.
Still don’t believe us? Let’s use some relatively simple math to illustrate how this works. Let’s assume the interest rate on a 5/1 ARM being one percentage point less than the rate on a 30-year FRM, while the value of the loan is $150,000. Multiplying 1 percent by $150,000 by the five years you plan to stay in the home, that’ll get you $7,500, which is the amount of money you’ll be wasting if you only stay for five years, just as planned. But there are also pitfalls if you stay longer than expected, say, ten years instead of the five years in which your rates will remain fixed if you choose a 5/1 ARM.
There’s a chance your interest rate can double in the five years after your initial rate expires, which means you would have been better off after all opting for a 30-year FRM. Long story short – make sure you have a good enough idea of how long you plan to stay in your new home before choosing whether to go for a typically long-term FRM or a typically shorter-term ARM.