When applying for a home loan, it is pertinent to understand the difference between a fixed rate mortgage (FRM) and an adjustable rate mortgage (ARM) as this will affect your mortgage payments. In short, an FRM is the fixed rate over the term of the loan and cannot go up or down as interest rates change. An ARM is variable and your mortgage can increase or decrease depending on the changing interest rates.
For example, if the current fixed interest rate is 3.875%, your mortgage rate will remain the same year-to-year. If the current ARM is 3.625% but when the interest rate increases, your ARM will also change to reflect the new interest rate. (ARMs are usually lower than the fixed interest rate.) It is important to note, however, that when an ARM goes down your mortgage may not (it depends on the type of ARM loan).
Discuss with your mortgage officer the difference between the two, the types of mortgages available and what interest rate is best suited for you. A couple of things to ask your loan officer regarding an ARM are: is there a cap on high or low the payments will go, how frequently the rates will change, and if you will be able to afford the mortgage when the interest rate increases.
As will all things in life, there are pros and cons to each:
- Adjustable Rate Mortage
- Pros: A Hybrid ARM could save you quite a bit of money on the initial fixed rate period. (Click the link to for more in-dept explanation of Hybrid ARMs.) Another pro to an ARM is that it could come with a cap so that your interest rate cannot increase above a certain percentage. This limits your long-term risk of rising interest rates.
- Cons: The cons to an ARM is that should the interest rate increase after the initial fixed rate term has ended the interest could substantially increase and send you into payment shock. This could also cause you to default if you aren’t prepared to pay more or cannot afford to pay more each month, especially if you plan on living in your home after the fixed rate term has ended.
- Fixed Rate Mortgage
- Pros: Monthly payments don’t change (unless property taxes, inscurance premiums or homeowner or condo fees increase). The market is difficult to predict and a fixed rate mortgage will give you peace of mind when the interest rates increase. And you’ll be able to shop around to compare rates with ease.
- Cons: If the rate is locked in at 4.5% but then goes down to 3.5% you may kick yourself for not waiting longer to buy. FRMs don’t usually come with the low intro rates that ARMs do. If you plan on selling or refinancing your home before the end of the loan’s term it could be a disadvantage.
Regardless of the mortgage you choose, you should always consult with your mortgage officer. Discuss the difference between an ARM and an FRM and which one is more advantageous for you and your situation. You don’t want to get yourself into something you don’t have a firm grasp on, as you could end up kicking yourself later and be sure you understand the terms for each type of mortgage. Your mortgage officer is there to explain, in detail, how interest rates work, how mortgages work and the types of mortgages available to you. Use this person to your advantage and ask for clarification if you don’t understand.
Sources: Thinkstock, nerdwallet.com, investopedia.com, consumerfinance.gov, realtor.com
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