Almost everyone who comes into my office wants to know the same thing. Should I get a mortgage with a fixed rate or one with a rate that changes?
Since your home is probably the most important thing you will ever buy, it makes sense to ask this question.
Fixed-rate mortgages look like the best choice for most homeowners at first glance. Depending on the length of your loan, you always know what your payment will be for the next 15, 20, or 30 years.
But wait, is that really the best option for you?
When you refinance, a fixed-rate loan may eliminate the risk of a rate increase in the future, but that benefit can make a big difference in your interest rate and payment amount. When they refinance, homeowners who choose long-term fixed rates pay between 1% and 2% more than those who choose an ARM.
If a homeowner refinances to a mortgage with an adjustable rate, they could save thousands of dollars in interest and fees. Often, it's the only way for a buyer to buy a home.
An ARM (adjustable rate mortgage) is the same in most ways. You get a lower starting rate than a fixed rate. Your rate or payment may go up or down at certain times, depending on the market and the details of your ARM plan. Most ARM plans limit how much your rate or payment can go up at certain times and over the life of the loan.
Pay close attention to the specifics of your ARM plan.
Let's say that after you refinance, your loan amount is $100,000, your starting interest rate is 1.25 percent, your loan term is 30 years, and your starting payment is $333.25 per month.
Let's also say that your payment is set at that rate for a year and that the worst thing that could happen is that it could go up by 7.5%. With a little quick math, you can figure out that the most your new payment could be on the 13th month is $358.24. That's only a $24.99-per-month increase. Does the fact that your payment is going up bother you?
Even though this example oversimplifies how an ARM loan works, the point I'm trying to make is that you should figure out what the worst-case scenario is for EACH of the maximum changes that can happen and ask yourself if the result is something you can handle. Can you handle the biggest possible rise?
By doing this homework, you'll kill the "unknown" beast that most homeowners are afraid of when they refinance or buy a home.
During some part of the loan period, most ARM plans let you refinance and switch to a fixed rate. If interest rates drop to an all-time low, you can always switch to a fixed rate loan for long-term security.
