Fixed rate loans vs. adjustable rate loans

Many people who did 100% financing when they purchased their homes two years ago, did so with an adjustable rate mortgage. Their rate was fixed for 2 years, the payment was affordable for them and the idea was that in two years, when their prepayment penalty dropped off, they would have enough equity to refinance into a longer term arm or a 30 year fixed rate. Then properties began to appreciate less then what was anticipated, some even declined in value. Many of those people find themselves with a much higher mortgage payment then they planned on and not enough equity to refinance. This is part of the reason that there is an increased number of foreclosures all over the country, but especially, here in the Las Vegas area.

Weigh very carefully the advantages and disadvantages of an adjustable rate mortgage, especially a very short term adjustable rate, like a two or three year. It can be the right choice in certain situations, but understand the dangers. Have your mortgage professional show you what your payment could be at the first adjustment and ask yourself if you can make that payment in case you cannot refinance at that time. If you absolutely can't, then it's better to get a longer term adjustable, like a five year, or a 30 year fixed rate, even if the payment is higher. Two years goes by faster then you think. It may mean you qualify for a less expensive home, but could save you heartbreak and financial stress later on. Currently, very few lenders are even offering 2 year terms.

What are the advantages of fixed rate versus adjustable rate loans?

With a fixed-rate loan, your monthly payment of principal and interest never change for the life of your loan. Your property taxes may go up, and so might your homeowner's insurance premium part of your monthly payment, but generally with a fixed-rate loan your payment will be very stable.

Fixed-rate loans are available in all sorts of shapes and sizes: 30-year, 20-year, 15-year, even 10-year and 40-year. Some fixed-rate mortgages are called "biweekly" mortgages and shorten the life of your loan. You pay every two weeks, a total of 26 payments a year -- which adds up to an "extra" monthly payment every year.

During the early amortization period of a fixed-rate loan, a large percentage of your monthly payment goes toward interest, and a much smaller part toward principal. That gradually reverses itself as the loan ages.

You might choose a fixed-rate loan if you want to lock in a low rate. If you have an Adjustable Rate Mortgage (ARM) now, refinancing with a fixed-rate loan can give you more monthly payment stability.

Adjustable Rate Mortgages -- ARMs, as we called them above -- come in even more varieties. Generally, ARMs determine what you must pay based on an outside index, perhaps the 6-month Certificate of Deposit (CD) rate, the one-year Treasury Security rate, the Federal Home Loan Bank's 11th District Cost of Funds Index (COFI), or others. They may adjust every six months or once a year.

CLICK HERE TO SEE CURRENT INDEXES AND INDEX HISTORIES

Most programs have a "cap" that protects you from your monthly payment going up too much at once. There may be a cap on how much your interest rate can go up in one period -- say, no more than two percent per year, even if the underlying index goes up by more than two percent. You may have a "payment cap," that instead of capping the interest rate directly caps the amount your monthly payment can go up in one period. In addition, almost all ARM programs have a "lifetime cap" -- your interest rate can never exceed that cap amount, no matter what.

ARMs often have their lowest, most attractive rates at the beginning of the loan, and can guarantee that rate for anywhere from a month to ten years. You may hear people talking about or read about what are called "3/1 ARMs" or "5/1 ARMs" or the like. That means that the introductory rate is set for three or five years, and then adjusts according to an index every year thereafter for the life of the loan. Loans like this are often best for people who anticipate moving -- and therefore selling the house to be mortgaged -- within three or five years, depending on how long the lower rate will be in effect.

When may it be a good idea to get an ARM loan?

You might choose an ARM to take advantage of a lower introductory rate and count on either moving, refinancing again or simply absorbing the higher rate after the introductory rate goes up. With ARMs, you do risk your rate going up, but you also take advantage when rates go down by pocketing more money each month that would otherwise have gone toward your mortgage payment. Remember, the average homeowner only stays in their home three to five years. This is especially true of first-time home buyers. The lower rate of an ARM loan may help you qualify for the home you really want.

Another reason to choose an ARM loan now is if you think your situation may change by the time the rate adjusts. For example, maybe right now you have a low credit score and can only qualify for a higher interest loan. A 30 year fixed rate might be too high in your credit score range, but an adjustable rate is affordable. You don't want to wait to buy a home due to rising property values so you purchase now at the ARM rate, and plan on refinancing when the rate adjusts, your credit score has improved, and you have more equity in your home.

We can help you determine the best way for you to go.