When considering your first home, you're faced with a lot of decisions: Downtown or the suburbs? Craftsman, ranch, or Cape Cod? Hardwood floors or carpet? These are all important, of course, but one crucial decision you'll face may be one you haven't examined. What kind of home loan would work best for you: a fixed-rate or an adjustable-rate mortgage (ARM)?
Choosing wisely could save you a lot of money and future anxiety.
Fixed-rate mortgages carry the same interest rate and monthly payment over the life of the loan. This stability makes fixed-rate mortgages a popular choice for many home buyers.
In today's low-rate environment, experts advise using a fixed-rate mortgage if you can. Though a fixed-rate mortgage may have a slightly higher rate than an ARM, the lack of surprise is appealing.
Market interest rates have been near all-time lows, says Mike Schenk, vice president, economics and statistics, at the Credit Union National Association (CUNA). They've recently increased and many believe they will be on a generally increasing path over long term. For that reason, borrowers who can afford a fixed mortgage should probably choose that option.
Generally, with an ARM you'll get a lower beginning rate, but it can rise or fall at specified intervals. This initial rate stays the same for a specific time frame but, when the introductory period ends, rates will change and the amount of a monthly mortgage payment can increase—sometimes substantially.
An ARM's interest rate is tied to a public financial index, such as a U.S. Treasury note. These loans come with two caps—one to limit how much the rate can climb at each adjustment, and another to limit the increase over the life of the mortgage. ARMs are listed as 1/1, 3/1, 5/1, and so on. The first number shows how many years the initial fixed rate will last. The second number indicates how often the interest rate will be adjusted after that. The "1" in these examples indicates an annual adjustment.
ARMs generally have caps on how much the interest rate can rise or fall. A common adjustable-rate mortgage is a 5/1 ARM with a 2/6 cap. This means the rate is fixed for the first five years and the interest rate and payment is reset every year after that period. The second set of numbers indicates the maximum increase in any year is limited to 2% and the maximum increase over the life of the loan is 6%.
So say you borrow $200,000 for a loan at an initial interest rate of 3%. Your monthly mortgage payment for the first five years of the loan will be $843. If the interest rate increases the sixth year of the loan by two percentage points, your payment will be $1,039. If the rate increases by two more percentage points in year seven and then again in year eight, your payment would end up being $1,471. You'd be paying $628.25 more for your monthly mortgage than when you originally took out the loan.
Consider your timetable
If you know you're going to move in a few years, the lower-rate ARM could save you money. Most of the time, however, the overall rate environment drives buyers' decisions.
In a high-rate environment, some consumers can afford to buy only if they qualify for a lower-rate ARM. They bet on rates dropping in a few years, when they hope to refinance with a fixed-rate mortgage. In a low-rate environment, buyers feel inclined to lock in that low rate while they can get it.
Talk with a credit union lender about your home loan options. If you're considering an ARM, be sure to find out how much your interest rate and monthly payments can increase with each adjustment. Learn how soon and how often your payment could go up.
Next, ask if there is a cap on how high your interest rate can go, and if there's a limit on how low your interest rate could go. Will you still be able to afford the loan if the rate and payment go up to the maximums allowed? Don't automatically assume you'll be able to sell the house or to refinance your loan before the rate changes.
"Understanding the terms and likely payment schedules is critically important for consumers," Schenk says. "As member-owned, democratically controlled financial institutions, credit unions do—and always have—cared deeply about ensuring members choose appropriate and affordable mortgages."
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