Choosing between a fixed-rate and an adjustable-rate -- also known as floating-rate -- mortgage is all about how much risk you are wiling to take on. Since lenders incur less risk with an adjustable-rate mortgage, they may go all out to make that type of loan as appealing to you as possible. Do your homework before taking on this type of loan to avoid finding yourself in an impossible financial situation down the road.
Fixed Interest Rates
Most first-time home buyers choose the stability of fixed-rate mortgages, according to government-sponsored Freddie Mac. With this type of mortgage, the lender sets an interest rate that does not change throughout the life of the loan.
Adjustable Interest Rates
An adjustable-rate mortgage, or ARM, offers the appeal of lower interest rates during the early part of the loan. After a period of anywhere from one month to five years, the lender may change the interest rate, also known as a variable or floating interest rate, at set intervals during the life of the mortgage. The lender bases the adjustment on an index that is usually reflective of the overall economy. A 5/1 ARM, for example, has a five-year period of a fixed interest rate, and then lenders may adjust the rate every year. These mortgages usually have caps on how much the interest rate can change at any adjustment period as well as a lifetime cap on how much the interest rate can adjust over the life of the mortgage.
Total Cost of the Loan
If a lender offers you a fixed-rate mortgage for 30 years at 6.0 percent and the prevailing interest rate rises to 11 percent at some point during the loan, you continue to pay the lower interest rate and the lender loses out. To compensate for this type of risk, fixed-rate mortgages usually come at a higher interest rate and with steeper closing costs and fees. The opposite is true for ARMs since lenders incur less risk as the mortgage’s interest rate fluctuates with the ups and downs of the economy.
Pros and Cons of Fixed-Rate Mortgages
If you prefer financial stability with no surprises, a fixed-rate mortgage might be your best bet. If prevailing interest rates take a sudden plunge, however, the only way you can take advantage of the lower rates is by refinancing the loan, which involves a new set of closing costs and fees.
Pros and Cons of Adjustable-Rate Mortgages
If you are on a tight housing budget or don’t expect to stay in your new home more than five years, consider an adjustable-rate mortgage. Your ARM allows you to take advantage of falling interest rates without an expensive refinance, but it also exposes you to the risk of rising interest rates. Before you sign on the dotted line, use an online mortgage calculator to see if your finances can withstand the worst-case scenario of your interest rate rising to the maximum allowable amount.
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