Understanding Traditional Fixed Rate and Adjustable Rate Mortgages

For most home buyers, the traditional fixed-rate mortgage and adjustable-rate mortgage (ARM) continue to be excellent options. However, even these traditional financing options require a number of important decisions. Should you get a 15- or 30-year loan? Should you get a fixed-rate mortgage to lock in today’s interest rates for the term of the loan—or take an adjustable-rate loan with a lower current rate and payment, but with the risk of rate and payment increases in the years ahead? 

 

 Fixed-Rate Mortgages: With a fixed-rate mortgage, you are guaranteed the same interest rate over the life of the loan. Your monthly payments never change, and the loan is paid off completely over the term you select. The key choice involves how long you have to pay back the loan. The most common options are 15- and 30-year loans, with the 30-year being the most popular. As this chart illustrates, a shorter-term loan comes with both a lower interest rate and higher monthly payments (so that you pay the loan back faster). Rates, and the differences between rates for 15- and 30-year loans, change daily.

 

Adjustable-Rate Mortgages: The initial interest rate on an adjustable-rate mortgage (ARM) is generally lower than that for a fixed-rate loan. However, with an ARM, the interest rate may increase or decrease in the future, and the sizeof your payments will go up or down along with the rate. Most ARMs are“hybrids,” meaning that the interest rate is “fixed” for a certain number of years after which the rate begins to “float.” The most common ARMs fix the initialrate for three, five, or seven years. ARMs are probably most appropriate for people who have sufficient financial resources to handle potential payment increases or know that they plan to sell their home around the time the loan’s interest rate is set to change.

 

Potential Pitfalls of ARMs: Even small changes in your interest rate can increase your monthly payment significantly, resulting in “payment shock.” Even a change of 1% or 2% in interest rates can result in a very big jump in your monthly mortgage payment. For example, if the interest rate on your mortgage changes from 4% to 6%, your monthly payment could rise by as much as 50%(from $1,000 to $1,500). ARMs can be complicated, and many specialty ARMs (with risky terms appropriate only for a small group of borrowers) are now being marketed widely. Be sure to avoid loans with terms that you don’t understand.

 

As always, your thoughts, questions, or comments are greatly appreciated. Let me know if I can help with any of your Charleston, SC real estate needs or questions.

 

“Carolina Joe”