Fixed vs. ARM: Which is Best For You?
Most peoples reaction the option of an ARM vs. Fixed is to autmatically to with the fixed rate. For some people that makes sense, but what are things you should consider before you making that decision?
The single most important factor in choosing your loan type is how long you plan on being in the home. If you think you will stay 7 years or less, an ARM is most likely a better choice financially. If you think you will move but keep the property as a rental or stay in the home for more than 10 years, the fixed rate is most likly best.
In the chart below is an example showing a 5 year period showing a fixed rate at 4.5% vs. a 5/1 ARM (fixed for the first 5 years). As you can see, at the end of 5 years you would have saved $7000 in payments and have $3000 more in equity.
In about 7 years (worst case scenario) it would have been to your advantage to have gone with the fixed rate.
If you like to make extra payments each month on your home, the ARM would be better because the interest is recast each year based upon the balance making more and more of your payment apply to principal.
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There are many different type ARM's that are availble to fit almost any situation such 1 year, 3/1, 5/1, 7/1 and even 10/1 ARMS. FHA and VA also offer ARM's with very conservative annual adjustments. Ask your loan officer to show you your options before assuming that a fixed rate is your best choice!
Helpfu tips and Ideas when considering which home loan to choose.
More about Adjustable Rate Mortgages
There are four basic “ingredients” in all ARMs, and different mortgages combine them in different ways. While your lender can tell you more about the ARMs available in your area, here are some helpful definitions.
Initial Rate: It typically will be 2 percent to 3 percent lower than a similar fixed rate mortgage.
Index: This is the economic “guide” or indicator used to determine changes to your ARM’s interest rate. Your loan is “tied” to this index. As that number rises and falls, so
does your interest rate. An example of an index commonly used for ARMs is the profit on a one-year Treasury bill (T-Bill); ask your lender for more detailed information.
Margin: This refers to percentage points the lender adds to the index to establish the actual interest rate of your ARM. This helps lower the risk for the lender. The margin
Adjustment Interval: This is the time between changes in your ARM’s interest rate. If your ARM has an adjustment interval of three years, your rate — and your
monthly payment — will change every three years, based on the current “index” plus your margin. Typical ARM adjustments periods are one year, three years or five years.
An ARM may contain limits that reduce the risk of extremely higher payments. One type of limit is a periodic cap that restricts the amount the interest rate can go up at
each adjustment. ARMs also usually carry a lifetime cap that limits how much the rate can go up over the life of the mortgage.
Bi-Weekly Payments: As with fixed rate loans, many ARM loans may be paid this way; check with the servicing company that collects your payments.
A Note on Other Mortgage Options
Lenders have developed what can be called “hybrid” mortgages to assist people in reaching their goal of homeownership. These loans can include combinations
of features of fixed and adjustable mortgages. You should check with your lender to determine the options that are available to you at the time of your home purchase.
What’s Wrapped into Your Monthly Mortgage Payment
Principal and Interest. Principal is the amount of money you borrowed. It begins, generally, as the sale price of the home you purchased minus the downpayment you made. With every payment you make, this figure will decrease. In the case of a 30-year fixed rate mortgage, only a small amount of your payment the first few years goes toward reducing the amount of principal. Interest is what you pay to borrow the money — it is “the cost” of using money that is not your own. At the beginning of your loan period most of your payment goes toward interest, but over time the amount applied to interest goes down and the amount applied to principal goes up.
What are the Other Parts of Payment That are not Principal and Interest?
In most cases a portion of your monthly mortgage payment is paid into an
escrow account, which is where money is held to pay taxes, homeowners insurance and mortgage insurance (if required). This is the element of the monthly payment that can fluctuate even in a fixed rate mortgage. Lenders sometimes require escrow accounts, but sometimes they do not.
Some people would rather pay their taxes and insurance themselves (waiving escrows), putting money aside every month to do it and gaining interest for themselves on those funds. In some cases the interest rate on your loan may be slightly higher if you choose not to have an escrow account and your first mortgage can not be more than 80% LTV.
Currently, most states permit lenders to collect two months of estimated annual real estate taxes and insurance payments at the closing. Afterward, your monthly payment will include 1 / 12 of the annual total for taxes, insurance and other anticipated charges (your lender may collect an additional amount to ensure that a two-month cushion is maintained in the account). Your tax and insurance bills are paid by the lender or servicing company that handles your payments. Together, all the parts of a mortgage payment are commonly called PITI (Principal-Interest-Taxes-Insurance).
The total cost of a mortgage involves more than just the interest payments you make. There are also origination fees, discount points and other miscellaneous costs. What’s more, there can be other terms and conditions that may affect the ultimate cost of your mortgage. When you compare different mortgages, be sure that you take into account all the factors that can influence your final costs.
A point is equal to 1 percent of the total amount of a mortgage; one point on a $100,000 mortgage is $1,000 (1 percent of $100,000). Generally, you will pay all points at closing. Most lenders offer mortgages with combinations of points and interest rates. Generally, the lower the interest rate, the more points you will pay at settlement. (Interest rates affect your monthly mortgage payment, while the points affect the amount of cash you must have at the settlement.) For example, if a loan with the current market interest rate has two points, a loan with an interest rate that’s one-half percent higher than the market rate may have no points. Your choice among the various interest rate/points options will depend on how much cash you have available for the closing and settlement.
Final interest rate
As you discuss different mortgages with your lender, there are other conditions and terms you should keep in mind. One of the most important is how and when the actual interest rate you will pay is determined. Most lenders will quote a rate and fee at the time you apply for a loan, and then guarantee — or lock — the quote for a specified time. While this protects you from paying more for yourmortgage if interest rates rise, it also means you will pay the quoted rate even if interest rates fall. Lock periods usually run from 10 to 60 days. Longer periods are sometimes available for an additional fee. You may want your lock period to be long enough to get you through closing and settlement. Some lenders give you the option of letting the interest rate for your mortgage float, so the rate can change between the time you apply and the time you close, but the rate is usually set after some specified period before the actual closing.
Courtesy of the MBA