When you are ready to buy a home, you will find that there are many mortgage options. But whatever loan program you use, the interest you pay will be structured in one of two ways: fixed or adjustable.
Although the majority of mortgage applications for refinances and purchases are for fixed rate loans, the variable rate option has some advantages that are often overlooked.
Understand the options
A fixed rate mortgage charges a fixed interest rate that remains unchanged for the life of the loan, usually 15 or 30 years.
With an adjustable rate mortgage (ARM), the interest rate varies throughout the term of the loan. The initial interest rate is usually lower than a fixed rate mortgage, and the rate is locked in for a certain period, usually 3, 5, or 7 years. Once the fixed rate period ends, the interest rate adjusts according to the index it uses. This means that your monthly payments can go up or down. Most ARMs include an interest rate cap that sets a limit to the height of the rate.
ARMs are categorized based on how long the interest rate remains fixed and how often the rate is subject to adjustment. For example, in a 5/1 ARM, the 5 is the initial 5 year fixed rate period while the 1 indicates that the interest rate is then subject to an adjustment once a year.
The pros and cons
Unfortunately, ARMs have had a bad reputation since the 2008 real estate crash. In 2005, around 40% of new loans were ARMs. However, many of these loans had risky features, including shorter fixed rate periods, negative amortization, higher lifetime limits, and prepayment penalties. Many MRAs have been approved with little or no money, and buyers often take out these loans without fully understanding their features and risks.
MRAs today are structured very differently than they were in the past, and Wayne Lacy, branch manager at Cherry Creek Mortgage, says they can be beneficial for some borrowers.
âIt depends on your goals and how long you plan to stay at home,â he said. âFor example, if you have a 3-year employment contract and know you will be moving afterwards, an MRA can be a great option. Or, if you buy a home as an investment with plans to repair it and sell it within the next 3-5 years, an ARM may work for you.
If you see your family staying there for more than 10 years, the typical advice is to go for a fixed rate mortgage. But Lacy says that even for buyers who are considering something longer-term, ARM may still be a good option.
âGenerally speaking, the average life of a mortgage is a little over 5 years,â he said. âAt this point, a lot of homeowners are selling or refinancing. So based on that statistic, the 5 Year MRA may actually be one of the best products out there. “
As always, there are pros and cons to each option. With a fixed rate loan, you get simplicity and predictability. But, interest rates are generally higher, which means less purchasing power and higher monthly payments.
By using an adjustable rate mortgage, you will benefit from lower and predictable payments during the fixed rate phase. If interest rates drop after the initial period, your monthly payment may go down. On the flip side, if interest rates go up, your payments might go up and some borrowers might have trouble making larger payments.
Although the eligibility criteria may vary from lender to lender, buyers who choose an ARM may need a higher credit score and a larger down payment than those who use a rate option. fixed. And, even if you plan to sell or refinance before the adjustable period begins, things don’t always go as planned. If you are unable to sell or refinance, you will have to pay your new rate.
The Consumer Financial Protection Bureau says that before choosing an ARM, it is important to know:
â How far can your interest rate and monthly payments go with each adjustment?
â How often will your interest rate adjust?
â How quickly could your payment increase?
â If there is a cap how high your interest rate could go?
â If there is a limit to the fall in your interest rate?
â Whether you will still be able to pay the loan if the rate and payment reach the maximums allowed by the loan agreement
âThere is never a single answer when it comes to mortgages,â Lacy said. âMRAs won’t be right for everyone, but I encourage borrowers to be more open about them. A reputable lender will discuss your options, make sure you understand the benefits and risks, and help you select the right loan product and terms that best suit your individual situation.
If you are considering buying a home and would like more information on the loan programs available, visit the Greater Lansing Association of REALTORSÂ® website at www.lansing-realestate.com for a list of lenders. of confidence.