The pair of you have been shopping for a home loan and the lenders have thrown you a twist. The initial interest rate and payments on a the five-year, fixed-period, adjustable-rate mortgage available to you are lower than what the classic 30-year fixed-rate loan offers. You know the latter is the safest way to go, but that out-of-the-gate low payment is tempting. Getting just the Joe Friday facts about mortgage options will help you pick the choice that works for you.
The 30-year fixed-rate mortgage is the mostly widely selected option for home loans. It keeps payments low and the fixed rate ensures there are no surprises, such as big payment increases. Selecting the 30-year fixed-rate loan is the conservative choice, and that may not be a bad thing. If rates go up, you show your financial smarts by locking in a good rate. If rates fall, you can refinance to a new, lower rate home loan.
Five-year, fixed-period ARMs are available from most lenders. These loans might be referred to as "five-year fixed" mortgages because the initial interest rate is fixed for that period of time. After the five-year period has expired, however, the loan becomes a one-year ARM. Starting in the sixth year, the rate can change every year for the remaining life of the loan and the payment could be higher or lower from year to year as interest rates change. The initial payment calculation for such a loan, which is also called a "5/1 ARM," uses the five-year rate and a 30-year term.
The appeal of the five-year ARM will be the lower rate and payment. At the time of publication, a major U.S. bank was quoting a 5/1 ARM at 1.375 percent less than the 30-year fixed rate. On a $100,000 loan, the payment savings would be $74.47 per month. Over the course of 60 months the savings add up to $4,468.20. The problem comes with that 61st payment based on the interest rate in effect then. The new payment could end up being higher for the balance of the loan's life and the long-term cost could be much higher than that of a fixed-rate mortgage.
Making a Choice
The decision to go with the five-year ARM depends on your financial outlook. If you can afford higher payments if rates go up after five years or you plan to sell the house within the five-year window, the lower rate and payments will work. If you are thinking about the five-year rate because your budget is too tight to handle the 30-year payment, you could be setting yourself up for financial trouble. With the five-year ARM, make sure you understand how new rates will be determined and the worst-case scenario, including the loan's maximum rate increases after the fifth year.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.