If you’re considering buying a new home or mortgage refinancing but aren’t sure which kind of loan is right for you you’re not alone. Both types of mortgage loans have advantages and disadvantages depending on your financial needs and comfort level with risk. Here are the pros and cons of fixed rate mortgage loans versus adjustable rate mortgage loans to help you make an informed decision.
Fixed Rate Mortgage Pros & Cons
Fixed rate mortgage loans are fairly self-explanatory in that your interest rate and payment amount will not change for the entire duration of your home loan. Most homeowners choose fixed rate mortgage loans for the stability of knowing what the payment will be month in and month out. That being said, fixed rate mortgages, especially those with 30-year term lengths have higher interest rates than similar adjustable rate mortgage loans.
When Should You Choose a Fixed Rate Mortgage?
Fixed rate mortgage loans are right for you if you plan on keeping your home for a long time, don’t like financial risk and are living on a tight budget.
If higher interest rates are putting you off choosing a fixed rate mortgage despite the advantages, consider shortening the term-length of your new home loan. Most people choose a 30-year term length without giving a second thought; however, choosing a 10 or 15-year mortgage will get you a lower interest rate and save you a bundle in financing.
Adjustable Rate Mortgage Pros & Cons
Adjustable Rate Mortgage (ARM) loans are intimidating for many homeowners. If you’re not familiar with how Adjustable Rate Mortgage loans work, the home loan is fixed for an initial period of time and then the interest rate and payment changes at a regular intervals. These home loans commonly get their interest rates from the LIBOR index, which is the London Interbank Offered Rate, a European index.
Adjustable Rate Mortgage loans are designated by their fixed period and time frame for reset. Common designations include 5/1, 7/1 and 10/1. The 5/1 Adjustable Rate Mortgage is fixed for the first five years and will reset every year after on the anniversary date.
The advantage of Adjustable Rate Mortgages is that interest rates can be much lower than similar fixed rate mortgage loans. Because ARMs are fixed for the initial period they are a popular choice for real-estate investors because of the lower payment amount. There are risks with Adjustable Rate Mortgage loans, mainly that if interest rates go up when your loan resets, your payment will also go up.
If your Adjustable Rate Mortgage is tied to the LIBOR index as many are, there is more risk because your home loan payment can be influenced by a struggling European economy.
Adjustable Rate Mortgage loans come with built-in safety features known as caps. Most ARMs have an annual cap which limits how much your payment can go up in a year as well as a lifetime cap, limiting how much the payment can go up over the mortgage loan’s term.
When Should You Choose an Adjustable Rate Mortgage?
Adjustable Rate Mortgage loans are right for you if you only plan on keeping the home for a short period of time, need the lowest possible payment and can tolerate financial risk.
Adjustable Rate Mortgages like the 5/1 ARM are a popular choice for real-estate investors flipping properties in a short amount of time. There’s a catch if you’re planning or refinancing or selling your home in the near future. Make sure your Adjustable Rate Mortgage does not have a prepayment penalty. Choosing a home loan with a penalty for early repayment will negate any savings you get from choosing an Adjustable Rate Mortgage for short-term financing.
Community based credit unions are a good place to start shopping for Adjustable Rate Mortgage loans that do not include prepayment penalties.
As you can see there are a number of advantages and disadvantages for both types of home loans. One last tip when choosing a fixed rate mortgage versus an adjustable rate mortgage loan: pay close attention to the fees you pay at closing.
Your closing costs make or break the deal you’re getting regardless of the type or how low your interest rate. Overpaying the origination fee or paying unnecessary discount points robs you of the benefit you’re getting from today’s low purchase and mortgage refinance rates from top lenders like Amerisave and Navy Federal Credit Union.
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