The choice between a fixed-rate mortgage (FRM) and an adjustable-rate mortgage (ARM) largely depends on your financial needs and goals. Here are some pros and cons for each option.
30-Year Fixed-Rate Mortgage: If it Ain't Broke...
The traditional 30-year FRM is the workhorse of mortgage loans. It offers these features and benefits:
- Stable principal and interest (P&I) payments. Mortgage payments remain stable from year to year. (However, note that if your mortgage payment includes provisions for taxes and insurance, those amounts are subject to change as property taxes and insurance costs change.)
- Full amortization. FRM payments are usually fully amortized, meaning that at the end of the loan term, you'll have paid off the money you borrowed. Though the amount of your monthly payment does not change, as the loan term progresses, a larger and larger portion of your monthly payment goes toward paying off principal (that is, your mortgage loan balance). If steadily paying down principal and building home equity is important to you, this is an advantage.
- No unpredictable features. FRM loans don't have features allowing deferred interest to be added to your mortgage balance, or for interest rates to change. If you don't like dealing with uncertainty in your mortgage loan or are the type to "set it and forget it," a FRM will fit your needs.
Adjustable-Rate Mortgage Loans Offer Short-Term Solutions
ARMs offer an initial fixed rate period, with the rate adjusting thereafter on a schedule according to predetermined rules. The popular 5/1 ARM provides an initial fixed interest rate for the first five years, then adjusts every year for the remainder of the loan term. What are reasons to use or not use an ARM?
- Low initial rate and payment. Given low initial rates, an ARM can help buyers qualify for a larger mortgage than they otherwise could with a FRM. This can be financially prudent if a home buyer has a lower income today but is confident about his or her ability to make potentially higher monthly payments in a few years.
- Financing for a starter home you'll sell soon. If you're planning to sell before the initial interest rate expires, an ARM can provide the steady payments of a fixed rate for a few years. However, if you take out an ARM mortgage intending on selling within a few years, beware of prepayment penalties and other features of the loan that may cost you later. A prepayment penalty is an extra charge assessed if you pay off your mortgage loan prior to a specific date.
- Don't pay an ARM and a leg. Pay close attention to how ARM terms can adjust or cost extra money. ARMs are tied to financial indexes, and it's important to understand how rate adjustments work. Selecting an ARM with rate caps (limits) can protect you from unmanageably large rate increases.
Before selecting any home loan, make sure your questions are answered to your satisfaction by your mortgage lender and that you fully understand all mortgage features, terms, and conditions.