Now that you’ve decided to buy your first home, you have many decisions to make and many mortgage-related terms to learn. Perhaps your biggest mortgage decision after picking the house is what type of mortgage to get – a fixed-rate mortgage or an adjustable-rate mortgage, also called an ARM. Fixed-rate mortgages are easier to understand, but ARMs can be a better deal.
The traditional mortgage is a fixed-rate one, meaning that the interest rate and the monthly payment remain the same throughout the course of the loan. A fixed-rate mortgage is a safe choice for conservative borrowers and an easy-to-understand one for first time home buyers. A fixed-rate mortgage also suits homeowners who plan to stay in the home for a long time. You never have to worry about your payments increasing due to an increase in interest rates. A fixed-rate offers borrowers peace of mind.
An ARM is attractive to many home buyers because you typically start out with a lower interest rate and monthly payment than you would if you opted for a fixed-rate mortgage. However, the interest rate and your payment can increase quickly with an ARM. If you are sure that you can afford the increased payments or if you plan to sell your home in a few years, consider an ARM.
Some ARMs allow you to convert to a fixed-rate for a fee. Make sure you can do this before you sign the paperwork. However, the Federal Reserve warns that consumers might not be able to convert before the interest rate and monthly payments increase. Also, you might not qualify at all if your home value or your income drops. You can refinance a fixed-rate mortgage, too, if the rates drop, but you have to pay closing costs.
ARMs are more difficult to understand than fixed-rate mortgages. If you and your partner go to a shady, or predatory, lender, you can be trapped into signing something you don’t really understand. With ARMs, lenders have more flexibility in determining caps on interest rates or the margin that is added to the index rate; unsophisticated borrowers could be agreeing to higher rates unnecessarily. Another example is that certain ARMs are negative amortization loans. Payments on these loans are very low, which attracts unsuspecting borrowers. But, the reason the payments are low is because you only are covering part of the interest due. What you aren’t paying gets rolled into the principal balance. You can end up owing more money than you did at closing. Some ways to spot a shady lender, according to MSN Money, are if the lender pushes you to accept terms that you can’t realistically meet, asks you to sign blank forms to “speed things up,” urges you to borrow more than you need and shows up at closing with a different loan product than you discussed.
If you know that you are going to move in, say, three years, you can take out a 3/1 ARM and be fairly safe. A 3/1 ARM means you have a fixed rate for three years. After that, the rate adjusts. You can also get 5/1, 7/1 and 10/1 ARMs. With these hybrid ARMs, your payments remain low for a fixed number of years and you can move before the rate adjusts. After the initial fixed period on any ARM, these loans typically adjust yearly; although some can adjust every month.
You might want to choose an ARM when interest rates are high because you probably would not want to lock in to a high fixed rate. When interest rates are low, however, a fixed rate starts to make sense. For a 30-year loan, 7 percent is not considered a bad lock-in rate.
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