Fixed vs. Adjustable

MOST FOLKS instinctively opt for a fixed-rate mortgage, where your principal-and-interest payment stays the same every month. But in all likelihood, an adjustable-rate mortgage, or ARM, will be cheaper. ARMs are priced off short-term interest rates, while fixed-rate mortgages are priced off intermediate-term rates—and short-term rates are generally lower than intermediate-term rates.

Moreover, when interest rates drop, homeowners with ARMs will likely see their monthly payment fall when their rate next resets. By contrast, for holders of fixed-rate mortgages to benefit from lower rates, they need to go through the hassle and cost of refinancing.

Of course, with an ARM, there’s also a risk that the interest rate will increase at the next adjustment date. ARMs often have both periodic and lifetime caps that limit how much the rate can increase. Let’s say an ARM has a two-percentage-point periodic cap, a six-point lifetime cap and a one-year adjustment period. Every year, the rate you’re charged could climb two percentage points, though it can never climb more than six points above your initial rate.

Not sure you want to take that much risk? Instead of a pure ARM, many homebuyers take out a 3/1, 5/1, 7/1 or 10/1 hybrid ARM. With these loans, your rate is fixed for the first three, five, seven or 10 years, and then the rate adjusts every year thereafter. At that point, the rate could climb sharply. But there’s also a good chance you might move or refinance within the first five or six years, so you may never feel the bite from the mortgage’s adjustable rate.

As you ponder what mortgage to get, give some thought to your job situation. If you have a secure job with a steady paycheck, you might take the risk of an ARM and, fingers crossed, get rewarded with a lower average rate over the course of the mortgage. But if your income fluctuates, you should probably look for predictability in the rest of your financial life, including favoring fixed-rate mortgages.

Next: Conforming vs. Not

Previous: Mortgages

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