Owning a house is a milestone most people want to achieve.
To make this happen, most people use a home loan to fund the purchase of their dream house. However, choosing a mortgage is not a slam-dunk process. It can be complicated, especially when you factor in interest payments that accrue on the principal.
One of the questions prospective owners are usually faced with is choosing between fixed or adjustable rates. Both options have a significant impact not only on your monthly payment but also on the total cost you would pay. Similar to choosing your home, the right mortgage for you depends on your need and financial situation.
This article highlights the differences between a fixed and adjustable-rate mortgage, and how you can choose the option that is the best for you.
What is a Fixed Rate Mortgage & What Are the Pros & Cons?
Fixed-rate mortgage
A fixed-rate mortgage is a type of home loan that has a fixed interest rate during its tenor.
The borrower pays the same amount monthly as a mortgage payment, regardless of benchmark interest rates. This is the most common type of loan for prospective homeowners. This predictability allows for better planning, which is good for those on a tight budget.
3 Benefits of a fixed-rate mortgage
1. Option of shorter loan tenor.
A fixed-rate mortgage comes with the option of choosing a loan with a shorter tenor. You can choose between a 15-year home loan or a 30-year mortgage.
A 15-year home loan comes with a lower interest rate, but your monthly payments would be higher.
*This is a good option for those who want to pay off debt faster and save money on interest payments on the loan.
2. Stability and predictability.
Because you know how much you are expected to pay monthly; a fixed rate mortgage allows for adequate planning.
*This measure of stability is good for those on a tight budget.
3. Not determined by benchmark interest rates.
Another advantage of a fixed-rate mortgage is that it is not determined by the benchmark interest rate which is set by the Federal Reserve. This implies, when the interest rate rises, a borrower could be paying below the benchmark rate, thereby saving some money.
3 Drawbacks of a fixed-rate mortgage
1. May pay higher interest rate.
One disadvantage of a fixed-rate mortgage is that you may pay higher than the benchmark interest rate.
During periods of slow economic growth and recession, the Federal Reserve may decide to reduce benchmark interest rates to stimulate borrowing and spending.
Home loans that were locked in a fixed rate before the recession would be paying above the market rate. On such occasions, you’ll need to go through the process and cost of refinancing to take advantage of lower interest rates.
2. Higher payments during the introductory period.
Interest rates payable during the introductory period may be higher than those offered on adjustable mortgages rates.
3. Penalties on early repayment charges.
Fixed-rate mortgages come with prepayment charges, meaning if you want to pay off your loan before the stipulated tenor, then you would be charged.
When is a fixed-rate mortgage good for you?
If you are conservative or risk-averse, then the fixed-rate mortgage is good for you.
You are not at the mercy of the whims of the economy. The predictability of making the same monthly payments throughout the loan tenor helps you to plan your finances.
As such, the mortgage tends to be less burdensome because the borrower would choose a loan they can afford to pay. This makes fixed rate mortgage a viable choice for those who have a low or fixed income
Fixed-rate mortgages are also good if you plan to settle down and live the rest of your life in the home. These types of loans are good for family houses or people whose jobs do not require them to change locations.
Adjustable-Rate Mortgages (ARMs)
An adjustable-rate mortgage (ARM) is a home loan with an interest rate that tracks the benchmark rate as set by the Federal Reserve.
The interest adjusts according to the market rates, as such, when the interest rate increases, there would be a corresponding increase in ARMs. Likewise, when interest rates decrease, there is a corresponding fall in ARM rates.
However, other elements of the loan such as the tenor and principal do not change. Most ARM rates are adjusted annually, though some lenders adjust more frequently such as biannually, quarterly or monthly.
4 Benefits of ARM
1. Lower introductory rates.
ARMs generally have a lower interest rate in the introductory period when compared to fixed-rate mortgages.
Because in the latter part of the loan tenor, the borrower is exposed to fluctuations in benchmark interest rates, they are compensated with a lower interest rate in the introductory period. The interest rate in the introductory period is fixed rated.
2. Flexibility.
If you intend to move in a few years or sell the house to raise capital, then you may consider an ARM. One way you can effectively utilize an ARM is by selling the house before the expiration of the fixed-rate period to avoid taking on less predictable interest rates.
3. Rate and payment caps.
Most ARMs include an interest rate cap as part of the contract terms. Caps limit the amount of your mortgage rate and the percentage of your interest rate payments adjustments. The caps apply to both increases and decreases.
4. No prepayment penalty.
ARMs do not have any prepayment penalty. This means you can pay above your required monthly contribution. You can take advantage of the fixed-rate period to pay off the loan thereby avoiding paying higher interest rates in the future.
4 Demerits of ARM
1. Changes in benchmark interest rate
If the interest rate rises, this would cost you more because your payments would increase during the adjustable period. If you don’t plan adequately, you might run into trouble when you have to make larger payments.
2. Less stability
Since interest rates are not fixed, this makes planning more difficult. This reduces your ability to take advantage of financial opportunities because you would want to keep some extra cash to accommodate any changes in monthly payments.
3. Only applicable to 30-year loan terms.
Unlike fixed-rate mortgages where you can get a shorter tenor, which allows the borrower to pay off his loan earlier, ARMs are only applicable to 30-year mortgages.
As such, unless the borrower can sell the home, he is stuck with the loan. When interest rates are rising, selling a house financed through an ARM may prove to be challenging.
4. Closing costs.
When you want to resell your house, you are expected to pay closing costs.
This can amount to between 2%-6% of the loan amount, which could run into thousands. Such an amount would have been better utilized under a fixed-rate mortgage. As such, it may be cheaper to rent if you are staying in the location for less than three years.
When is an ARM good for you?
ARM is definitely for those with a short-term objective and appetite for risk.
If you intend to relocate or flip your house, it would make sense to go for an ARM. You can take advantage of the fixed-rate period to pay a lower interest rate before selling the home.
Because interest rates are fluctuating, you have to be prepared financially to absorb the risk. This entails saving extra income to accommodate any increment in monthly payments. One way to go about this is by using the caps on the interest rate to make projections on future monthly payments.
Final word
Paying for a home is a huge financial commitment.
Before you decide on which interest rate would be appropriate to you, you should consider prioritizing what suits your unique situation. Ascertain the level of risk you are comfortable with, including the flexibility of your income bracket.
You should also consider your life goals and aspirations before committing to owning the home or using it for the short while before moving on.
