An ARM, also known as a variable-rate mortgage, is a loan that starts out at a fixed, predetermined interest rate, likely lower than what you would get with a comparable fixed-rate mortgage. However, the rate adjusts after a specified initial period -- usually three, five, seven, or 10 years -- based on market indexes. If those indexes go up, your payment will go up. However, if the indexes don't go down, that doesn't necessarily mean your payments will, too. Be sure to read the fine print on your mortgage.
A fixed-rate mortgage is just that: The interest rate, and your payments, stay the same for the life of the loan, be it 15, 20, or the most common 30 years.
So why might you choose one type of loan over the other?
If you're a home buyer with a steady career who wants to put down roots in a community, a fixed-rate mortgage might appeal to you. This kind of loan is also advantageous to people approaching retirement, because the fixed payments make it easier to plan their finances.
The majority of homeowners tend to prefer fixed-rate mortgages, according to Wells Fargo Home Mortgage Area sales manager Chris Jurilla.
"Fixed-rate mortgages provide more long-term stability, and with rates still low, borrowers prefer the security of not risking a rate increase or adjustment if the market were to turn," Jurilla says.
- Rates and payments remain constant.
- You can budget more easily.
- It's more straightforward than an ARM.
- It's more appealing for the risk-averse.
- You won't be able to take advantage of falling interest rates without refinancing.
- You may not qualify for as much house as you would like, because payments are typically higher.
If you're a more mobile or first-time home buyer who wants to keep your long-term options open, an ARM may be preferable. As long as you're ready to move on before the introductory period ends, you'll benefit from the advantage of making lower payments while you're living in the home. And because your lender will be qualifying you on the basis of a lower monthly payment, you could qualify for a more expensive house than you would with a fixed-rate mortgage.
"ARMs are best suited for investors or buyers who have short-term ownership goals in mind," says Jurilla. "Most opt for an ARM if they don't foresee themselves staying in the home for an extended period of time. There are some who use it as a 'steppingstone' loan, a short-term solution with a lower monthly payment."
- There are lower rates and payments early in the loan term.
- You have a better chance of being approved for a bigger and/or more expensive house (because your lender will use the lower payment when qualifying you for the loan).
- You'll automatically take advantage of lower rates without the hassle and expense of refinancing.
- After the introductory term, payments and rates can rise substantially.
- You'll need to understand complicated terms of your agreement, such as margins, caps, and adjustment indexes.
- If you have a specific kind of ARM called a negative amortization loan (or NegAm), you may find yourself owing more money than you did at closing. (That's because payments are set so low that they cover only a part of the interest due, and the rest is rolled into the principal.)
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