A Fixed-Rate or an Adjustable-Rate Mortgage: Which is Best?

Whether to take a fixed-rate or a adjustable-rate mortgage is one of the most important financial decisions when shopping for a home loan.
Fixed-rate mortgages are the traditional type of home loan.

You borrow an amount of cash that you promise to repay at a fixed interest rate over a certain period of time.

The monthly payment is fixed and stays the same throughout the life of the loan.

An adjustable-rate mortgage a loan in which the monthly payment and home loan balance can fluctuate because the interest rate on the loan can either increase or decrease over the life of the loan.

There are many types of adjustable-rate mortgages, but they generally work in a similar fashion. The mortgage interest rates can change at the end of an adjustment period.

The adjustment period may be every month, every six months or annually, or the loan may have an adjustment period after 3, 5, 7 or 10 years.

The interest rate changes because it’s linked to an index such as three-month, six-month, one-year Treasury bills or a cost of funds index.

Whichever index is used, it essentially reflects the cost of money to the lender. The mortgage company makes a profit by adding a margin (0.5 percent to 1 percent) to the index.

The lender cannot raise the interest rate beyond a predefined rate if there is a lifetime cap on the home mortgage loan. This puts a limit on the highest interest rate the lender can charge on your mortgage.

So even if the index skyrockets, your rate has a maximum. This also works in the opposite direction. If the index bombs, the interest rate has a minimum that it cannot go below, so the lender is protected.

Many lenders offer a period cap that limits how much your mortgage interest rate can change at the end of each adjustment period, usually 1-2 percent above (or below) the current rate.

There are other common components within variable-rate mortgage loan agreements that you should be aware of, such as the conversion feature, prepayment terms, and negative amortization.

SO WHICH MORTGAGE OPTION IS BETTER?

The best type of mortgage for you depends entirely on your circumstances: your financial situation, comfort zone, how long you plan to keep your home, what amount of monthly payments you can comfortably afford.

IN FAVOR OF AN ADJUSTABLE-RATE HOME LOAN

Usually has a lower initial interest rate than fixed mortgages; therefore, you have lower initial monthly payments for the same amount.

With lower payments required, it may be easier to qualify for a mortgage. First-time home buyers often choose variables for this reason.

You may be able to qualify for a larger home loan if the mortgage lender bases the decision on your ability to make payments.

If interest rates drop, stay the same or rise only a little, an adjustable-rate loan may cost less interest over the long run than a fixed.

A variable may be a good choice if you do not plan to stay in your home a long time because the risk of rising mortgage rates may not affect you all that much over the short term.

IN FAVOR OF A FIXED-RATE MORTGAGE

You always know what your payments will be.

With an adjustable-rate loan, you assume the risk that interest rates will increase. Over a 15 or 30-year term, changes in interest rates are certain to occur. If the rate increases, will you be able to handle increased payments?

Because a fixed-rate mortgage gives you certainty, you can predict what your mortgage needs will be and budget accordingly.

A lot of people believe that if they cannot afford their house sometime in the future they can just sell it. This may be easier said than done.

Another factor in considering which type of loan is right for you is equity in your home and its marketability. The real estate market is just like the stock market.

By that measure, it goes up and down on a daily basis based on the number of buyers and sellers willing to transact business.

If your house is in a market with declining demand (or can be) and rates rise, you may have a difficult time selling without lowering the price.

Whichever direction you decide to go, here’s a brief mortgage checklist before you begin…

• Establish your goals
• Update your budget and determine what you can afford
• Check on your credit — order credit reports
• Talk to your financial advisers about your situation and select a mortgage broker
• Become familiar with mortgage refinancing as well as the various types of mortgages and what is required of you with each
• Decide on a fixed-rate or adjustable-rate mortgage
• Gather required information and documents and complete the application
• If and when you proceed with it, monitor the refinance process
• Evaluate homeowner’s and liability insurance needs
• Make sure the details of the new mortgage are as expected

SOURCE: Modesto Bee