When you’re buying a house, it’s highly likely that you’ll need financing and may run into questions regarding a mortgage. How much money do you need to borrow? Should you opt for a 15-, 20-, or 30-year term? Which lender will offer you the best loan options and the most competitive rates? And most importantly, how much home can you afford?
Did you know that there are actually different types of mortgage loans and within these loan types different down payment and other program variances? That means there will likely be some research involved to help identify which lender and program best fits your needs.
If you’re in the market for a mortgage loan this year, this may be one of the first questions you have to ask yourself before taking the plunge. The most common types of mortgages are fixed and adjustable-rate mortgage (ARM) loans. The main difference between the two lies in how borrowers are charged interest.
Each of these different loan programs may have their own advantages, so the key is to choose the best home loan option for your particular situation. Let’s review a few basic options.
Fixed-Rate Mortgage Loans
In a nutshell: long-term predictability.
As its name suggests, a fixed-rate mortgage (FRM) has an interest rate that stays the same for the entire life or “term” of the loan, even if it’s 30 years. The rate remains fixed regardless of any changes that might occur in the broader economy.
Pros of Fixed-Rate Mortgage Loans
Fixed-rate mortgage loans offer greater stability and predictability over the long term when compared to their adjustable counterparts.
By its nature, a fixed-rate loan shields you from fluctuating interest rates. Interest rates tend to rise during periods of economic growth, so the cost of borrowing can rise as well. But with an FRM, you can lock in a mortgage rate and preserve it for the life of the loan—even if lending rates rise significantly during that period.
Cons of Fixed-Rate Mortgage Loans
Generally speaking, fixed-rate home loans have higher interest rates than most introductory rates on adjustable-rate mortgages. The differential between a fixed and the initial introductory adjustable rate depends upon things like market conditions and the Treasury bond yield curve. It’s the price you pay for stability and predictability.
The difference between 4% and 4.5% on a long term fixed rate mortgage, for example, may not seem like a notable difference—but it can be. Using a mortgage calculator you can calculate this simple example.
Let’s say you buy a house, and the purchase price is $240,000. You put down 10%, or $24,000, and finance the remaining $216,000. If you chose a 30-year fixed-rate mortgage and secured a 4.5% rate, you’d pay $1,094 per month. If you chose a 7/1 30-year adjustable-rate mortgage and started at the fixed introductory rate of 4%, your monthly payments would only be $1,031 for the first seven years.
That means that choosing a fixed rate would cost you an extra $63 per month in payments and with regards to interest paid at the end of seven years between the two, interest paid at 4.0% is $56,510 vs 4.5% $63,909. After the initial 7 years, the adjustable rate can change annually.
Lifetime rate caps on these hybrid type loans are typically 5% above the introductory or start rate. It is recommended before you commit to an adjustable rate mortgage, that you calculate what your maximum rate cap/payment may be so you can view the worse case scenario before signing on the dotted line.
Interest rates can affect home loan borrowers more than they realize. Sure, your home loan rate might be lower than the rate on your credit card or student loan. But because so many home loans contain much higher balances than other types of loans, tiny differences in percentages could make a noticeable difference depending upon your loan balance and amortization period.
Of course, the rate you receive from a lender will depend on several variables, including but not limited to the loan program you choose, type of property, credit score. For some borrowers, the advantages offered by a fixed rate loan outweigh the potentially comparable initial higher interest charges.
This may be especially true for home buyers who are planning to stay in a house or at least keep the loan, for a longer period of time. For example, SoFi offers fixed-rate mortgages with 15- and 30-year loan terms. This means the fixed rate you receive up front will stay the same for 15 or 30 years, respectively.
Bottom line: If you are planning to own your home for the long-term and want to avoid the uncertainty of a variable interest rate, consider choosing a fixed-rate loan.
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Adjustable-Rate Mortgage Loans
In a nutshell: initial lower rates, more risk.
An adjustable-rate mortgage (ARM) loan is so named because the interest rate can change over time. In many cases, an ARM loan’s rate will stay the same for a specified period of time, such as five or seven years.
These types of loans are sometimes referred to as “hybrid” loans; fixed for an initial period of time such as 3, 5, 7 or 10 years, then after the initial or introductory fixed period they become adjustable rate mortgages, usually with an annual adjustment period.
ARM loans are usually labeled with numbers that delineate a) the length of the introductory fixed phase, and b) the frequency of rate adjustments following the fixed phase.
For example, SoFi offers a 7/1 adjustable-rate mortgage that has a fixed interest rate for the first seven years, after which time the rate changes annually usually based on the 1-Year LIBOR index. And for many first time home buyers or others who plan to refinance or move, they still have the option to pay off the loan before the seven year fixed period ends with no prepayment penalty.
Check the loan terms and ask questions. Is the loan fully amortized with full principal and interest payments throughout or is there an interest only payment option period? What is the lenders margin which is added to the ARM index (LIBOR)? What are the annual and lifetime caps that the loan can adjust to?
Pros of Adjustable-Rate Mortgage Loans
So why would anyone want a mortgage loan with a rate that changes over time? Why choose an ARM over the stability of an FRM? The reason can be summed up in a single word—savings. Borrowers who choose adjustable mortgage loans tend to secure lower initial interest rates than those who use fixed-rate loans.
If you’re concerned about the risk of rising interest rates, many ARM loans have caps on how much the interest rate can increase or decrease. There is usually both an annual limit and a lifetime limit. For example, an ARM loan may specify that the maximum interest rate adjustment each year cannot be more than 2%, and cannot be more than 5% over the life of the loan.
Cons of Adjustable-Rate Mortgage Loans
As you may have figured out by now, ARMs provide less stability than FRMs. This can prove to be a shock to your bank account every year, especially if rates consistently increase.
Another con is that adjustable-rate mortgages can offer interest only payment options for the first 10 years or so. This means you may not be paying down principal during that time. As you can see, different types of home loans offer different pros and cons.
Once you shop around and identify the loan program that best suits your needs, such as a conventional loan or a government loan; you will then be better informed as to what type of amortization that particular loan program offers. For instance, some first time home buyer loan programs may not allow for interest only or adjustable rate payments and may only offer a fixed rate option for stability.
Tips for Choosing Between a Fixed-Rate and Adjustable-Rate Mortgage
Now that you know the differences between fixed-rate and adjustable-rate mortgages, you may have a better idea of which one suits your needs. But in case you’re still on the fence, there are a few factors you may want to take into consideration before taking out a home loan.
Think about How Much You Have to Put Down
The amount of money you have for a down payment and other qualifying criteria may dictate the home loan programs you will likely choose or be eligible for, this in turn may dictate what loan program type (fixed/arm) the lender(s) offer.
Think About How Long You May Keep the House
For whatever reason, you might have no intention of completely paying off your mortgage and living in this house for the rest of your life. Numerous circumstances can make us decide to move, be it a new job, a growing family, or moving to take care of a loved one. If you have choices on the types of loan programs you can choose from,
Take time to think about how long you are likely to live in this home or keep the loan if you move and retain the property as a rental in the years that follow. If you only plan to retain the property for five years, you may be tempted to consider an adjustable-rate mortgage with a fixed introductory period because in most cases, ARM start rates are typically lower than fixed-rate mortgages, and you might sell the house or refinance before that low introductory period ends.
If you look back at our example of a fixed rate payment and interest vs an ARM, you can see that someone planning to sell or refinance during the initial ARM fixed rate period, could save thousands of dollars by choosing an adjustable rate option. However, if they retain the house and loan after the initial fixed rate period, there’s potential for that adjustable rate to increase.
Consider How Quickly You May Want to Pay off Your Mortgage
Maybe you do think you’ve found your forever home, or at least a home you’ll live in long enough to pay off the mortgage. Ask yourself how long you may want the term of your home loan to be.
You’ll frequently hear about 30-year or 15-year mortgages, but some people who can afford to make a higher monthly payment, take out 10-year loans. Even if you initially take out a mortgage for a certain number of years, you have the option to pay it off early or to refinance into a different loan.
If you take out a 30-year mortgage, home loan rates have the potential to fluctuate a lot during that time. In this case, choosing a fixed-rate mortgage could help you secure a low rate and feel peace of mind. You won’t have to worry about monthly payment amounts potentially increasing.
Understanding How Your Adjustable Rate Would Work
If you’re seriously considering an adjustable-rate mortgage, it is highly recommended that you know all the facts before making a commitment. What’s the limit on how high/low the rate can go, and how often will the rate change?
If your rate reaches the maximum, would you still be able to afford to make payments? When rates change, how quickly will that affect your monthly payment? Calculate all these contingencies with your potential lender.
Each lender is different, so don’t make any assumptions about how your adjustable-rate mortgage will play out. After learning the loan details, you may decide that an ARM is right for you. If you aren’t comfortable with the terms, you might opt for a fixed rate.
Buying a home is a huge financial step, and all the loan option decisions can feel overwhelming. A dedicated SoFi mortgage loan officer (MLO) will be happy to talk with you about any questions you have regarding your home loan options. Hopefully, they can help make the process less stressful and more exciting.
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