The Pros and Cons of Fixed and ARMs
Not so long ago, anyone looking to buy or refinance a home could have easily been overwhelmed by the choices available in mortgage loan types. Let’s see…there were fixed rate loans, ARM loans, interest-only loans, negatively-amortized loans --- you name it, you could find it. For better or worse, those days are gone, as banks have substantially reduced their product offerings to consumers due to economic factors beyond the scope of this blog. But here’s what the savvy borrower needs to know about the most common loan types still available.
Fixed Rate Loans
Most of us intuitively understand this type of loan, and given a choice, most of us select this type of loan. The concept is straightforward. Take a loan balance and pay it off over 15 or 30 years, all the while making an identical payment each month. There is no risk of a payment increase and you can “set and forget” your household budgeting, at least as far as your housing expense goes. Fixed rate loans will usually have a slightly higher rate than any ARM (adjustable rate mortgage) loan, as you pay a premium for the risk you don’t take. There are a few other notes about fixed rate loans:
* It is possible to have a fixed rate loan with an interest-only payment feature. This would imply that your loan’s rate will stay the same for the entire term, let’s say 30 years. Your interest-only payment option may be in play for only the first 10 years of the term, and you would enjoy a lower payment during that time. At the beginning of year eleven, however, the remaining loan balance would be amortized (that is, scheduled to be paid off) over the next 20 years, thus increasing the payment as a result. If you have one of these loans, you must understand that “fixed rate” is not synonymous with “fixed payment.”
* FHA loans are not always fixed rate loans, though certainly they are the most common type of FHA loan. Having an FHA loan simply means that the Federal Housing Administration has insured the bank providing the loan product, whatever product that may be. It also bears mentioning that outside of the FHA insurance, an FHA 30-year fixed rate loan works just like any other fixed rate loan. At the core, it is the same product.
An adjustable rate mortgage (ARM) is a loan product that can be used to provide a rate and payment advantage to the customer who perhaps has either a shorter time frame in the home in mind, or a higher risk tolerance when it comes to payment fluctuation. The most common ARM loans these days are actually better referred to as “hybrid ARM” loans: they are actually fixed rate loans, but fixed only for a portion of the whole term. For example, a 5/1 ARM loan is really a 30-year term (not 30-year fixed), though the interest rate is only set for the first five years of that 30 years. After year five, the rate would begin adjusting on a periodic basis, usually either every 6 months or one every year. Here are some other important notes on ARMs:
* ARM loans are NOT balloon loans. So, you are never forced to pay the balance of the loan in full. Sure, your payment and rate could go up or down, but the loan is still going to be amortized over the full term.
* All ARM loans have interest rate caps. These prevent the rate from going ever skyward, or below a certain floor. The cap structure is something about which you should consult your loan officer, as a favorable cap structure can sometimes make a good ARM loan even more appealing. Conversely, an unfavorable cap structure leaves you open to a big payment/rate increase once the fixed term of the loan expires.
* When an ARM loan converts from fixed to adjustable, the bank will usually determine your rate by combining an index (such as the 6-month LIBOR or 1-Year Treasury) and a margin. The margin, like the cap structure above, is set at the origination of the loan.
* It is also possible to have an interest-only feature on an ARM loan. Usually, but not always, the interest-only period will coincide with the fixed rate period.
So which loan type is best? Unfortunately, there is no singular correct answer. Your best strategy in determining what is right for you. Contact your loan agent and work together to make an informed choice. If you do not have a loan agent, let me know as I can refer you to people who are very knowledgeable so you can Ask questions. Do your homework. And last but not least, earnestly assess your own attitudes about money --- they are as valid a reason for your choice as any other. If I can help in any way, just contact me. My contact information is below.