The good news about shopping for mortgages is that you have lots of options. Here’s a look at one of the many questions you’ll have to consider: Is an adjustable rate or fixed rate mortgage best for you?
Many home buyers focus on finding the lowest mortgage rate at the time they’re buying their home, and a five-year adjustable rate mortgage (ARM) often looks quite appealing to them. But it’s important to understand that an ARM rate adjusts at the end of the initial term. For example, a five-year ARM only has a fixed rate for the first five years; then the rate adjusts once per year for the next 25 years. This could be a good option if you plan to be in the home less than five years.
If you intend to be in the home for more than five years, however — and especially if you’ll own it for more than 10 years — the risk of a five, seven, or even 10-year ARM is too great, given future rate adjustments that can cause your monthly payment to spike.
Crunching the numbers
To put it in perspective, suppose you are making a $300,000 home purchase price with 20 percent down on a home you want to stay in for longer than 10 years, and you have a credit score of 760.
Today, this scenario might result in a 3.25-percent rate on a five-year ARM. Appealing, indeed — especially when you compare that to today’s 30-year fixed rate at 3.875 percent. (Remember, rates change throughout each day).
What many home buyers forget or don’t know is that today’s 15-year fixed rate is also 3.25 percent.
From a pure financing cost standpoint, a 15-year fixed is the same as a five-year ARM — at least for the first five years. The trade-off is that the payment on a 15-year fixed is higher because the loan is amortized over 15 years. By comparison, both a five-year ARM and a 30-year fixed are amortized over 30 years.
Using these rates as an example, here are the payments for each type of mortgage. (These examples are mortgage payments only, excluding taxes and insurance. To get the full monthly cost, use a mortgage calculator to run customized scenarios.)
- 15-year fixed payment: $1,686
- 30-year fixed payment: $1,129 ($557 lower than the 15-year payment)
- 5-year ARM payment: $1,044 ($642 lower than the 15-year payment; $85 lower than the 30-year payment)
The important point to keep in mind is that after five years, the ARM payment will jump to $1,447 — and it will adjust every year thereafter, creating unnecessary risk for someone who intends to keep their home for the longer term.
A better option than ARM
Clearly, an ARM isn’t the best option for long-term home buyers. But what about comparing the fixed rate options?
In the example above, the 15-year loan is $557 more per month than the 30-year loan — but you’re going to pay your 15-year loan off in half the time.
If your budget can accommodate the higher payment on the 15-year loan, not only will you pay your loan off early, but your interest rate is .625 percent lower, saving you $102,732 in total interest paid over the life of the loan.
If your budget cannot accommodate the full amount of higher payment on the 15-year loan, you can also consider taking the 30-year loan and paying a smaller extra amount per month. Here’s how making extra payments can save you time and money on a 30-year fixed loan.
|If you pay this much extra per month||You’ll save this much in interest||And pay off your loan this much earlier|
|$200||$45,510||7 years, 4 months|
|$300||$59,781||9 years, 9 months|
|$400||$70,949||11 years, 8 months|
You can shorten your loan term and save money by paying extra on a 30-year fixed each month, and still have the safety net of a lower required payment than on the 15-year fixed.
When you get pre-approved for your home purchase, ask your lender to run these comparisons for you to determine what loan is best for your budget and your expected time in your new home.