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What Is the Best Mortgage Now: Fixed or Variable-Rate?

By the Mortgage Guy / MortgageLoanRequest.com


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It was recently reported that for the week ending March 25, 2011, that national median mortgage rates were 4.79% for a 30-year FRM (Fixed Rate Mortgage) and 3.41% for a 5/1 ARM (Adjustable Rate Mortgage). The monthly principal and interest due on a FRM for a $200,000 loan is $1,048.12 and $888.07 for an ARM. Because the ARM is $160.05 less per month for five years the initial savings is $9,603. So, if $1,048.12 per month is affordable a home owner could use that same ARM to qualify for a larger mortgage of around $36,000.

The Basics

There is no firm metric to gauge whether an ARM or a FRM is the best choice in today’s mortgage market because each borrower’s circumstances and ability to repay a loan are totally different. Prospective borrowers are encouraged to shop around and talk to lenders and their real estate advisor to see where they stand relative to their credit score, current and projected monthly incomes, and the amount they are able to put down. In this way a prospective borrower can see what is actually available to them and leave no room for speculation or wishful thinking. Once all the different scenarios have been quoted the mortgage shopper can then comparatively analyze the loan offers and determine whether an ARM or FRM is best for them in the long-term.

The Available Options That Should Be Considered

Type of ARM
Fixed-period ARMS afford borrowers plans that are anywhere between three and ten years in length before the initial interest rate will adjust. Once the initial time period has elapsed the mortgage will then adjust every year. Fixed period ARM terms which are typically tied to the one-year Treasury securities index can be:

  • 30/3/1
  • 30/5/1
  • 30/7/1
  • 30/10/1

ARMs with an opening fixed period beside of lifetime and adjustment caps as a rule also incorporate a first adjustment cap. The cap limits the first time adjustment of the interest rate. Different loans have different adjustment cap terms. The cap limits the interest rate a borrower will pay the first time their rate is adjusted.

Lenders favor these types of loans, where the interest rate is lower than for a 30-year fixed, because they are not locked in for as long, consequently their risk is lower, and they can charge less. Borrowers like these kinds of loans because they still get the benefit of a fixed rate for a specified number of years.
The most commonly available option is the 30/5/1 ARM, followed by the 30/3/1 ARM. The longer the initial period, the smaller the difference will be between the interest rate of the ARM and the interest rate of the FRM.

Payment Difference

In the beginning of this article we site a $200,000 example for a typical mortgage. If that mortgage amount were to be cut by fifty percent to $100,000 the difference in monthly payments is then $80. This may not be a big enough difference that would allow a borrower to assume some of the additional risks associated with an ARM, and that should be determined by their unique financial situation. But in some cases if $80 is a determining factor the borrower needs to seriously consider if they can truly afford all the cost and expenses that home ownership entails.

Some people are looking to borrow so that they can trade up to a better home and living situation. These property owners need to judge for themselves whether the difference in the prospective new property they can acquire with the ARM makes the interest-rate risk worthwhile. Regardless of how much they may want to get themselves and their families into better homes, better neighborhoods and schools and an up-graded lifestyle they still must weigh the risks and rewards before taking the leap. They need to visualize their situation five years down the road, and the prospect of mortgage payments that have possibly increased 100%, and only then decide if the gains are worth the gamble.

Risk Tolerance and Future Plans

Not being able to gaze into a crystal ball and see the future creates risk for investors. ARMs are tied to what is known in the real estate industry as interest-rate risk. Once the inaugural period has passed the interest rate for an ARM will adjust to and reflect the current market conditions. Not knowing what those interest rates will be three, five, seven, or ten years down the line creates a risk that many homeowners may not be able to absorb.

Borrowers who seek ARMs should be confident that they would either be selling their property, have a substantial increase in their income, or be refinancing their mortgage before the loan adjusts - or finally, that interest rates will either drop or remain static which would in turn provide them with a comparable rate to their introductory rate when the loan resets.

Adjustable Rate Mortgages may seem to be advantageous at first because they offer better terms than other types of mortgages, but the unknown risks and hidden costs down the line are what make can them less attractive when viewed with a discriminating eye. Borrowers who enter into ARMs should be more than assuming that they can suffer the higher rates and payments.


 
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