Stuart Epstein, the
Maryland mortgage consultant, explains the difference between a fixed-rate and
an adjustable-rate mortgage.
Just as you research which type of car is the most practical
and suitable for your lifestyle, you need to do the same with a mortgage. There
are two general types of mortgages -- fixed-rate and adjustable-rate. The
entire list of mortgage types is much more extensive, but they all fall under one
of these two categories. Determining which type of mortgage is the better
choice for you is an important task to complete in the early stages of the home
buying process. So, what’s the difference…and more importantly, which is best
for me?
Fixed-Rate Mortgage
This type of mortgage has an interest rate that will remain
the same for the entire existence of the loan. Fixed rate mortgages are usually offered
in terms of 10, 15, 20 or 30 years. Even though the interest rate is
fixed, the amount of interest that you pay during the life of the mortgage
depends on which term you choose.
An advantage of a fixed-rate mortgage is that your interest
rate will never change even if the index of interest rates rises. This will help with budgeting
because you will always know approximately how much your monthly payments will
be over the course of the loan. Those
payments may change somewhat if property taxes, insurance or other escrow items
go up or down, but the largest components of your payment, principal and
interest, will remain the same.
A disadvantage of this type of mortgage is that since your interest rate
is fixed, you may pay more interest over time if rates fall.
Adjustable-Rate Mortgage (ARM)
With this type of mortgage, the interest rate fluctuates
based on a specific benchmark. Initially, the interest rate will start out low,
usually lower than the market rate, and then it can rise (or fall) over time.
This initial rate could remain constant for months or years. After this
introductory period, your interest rates and monthly payments will most likely
rise, and your rate will fluctuate with market rates over the life of the mortgage.
The lower initial payments are a central advantage of an adjustable-rate
mortgage, and may allow you to qualify for a larger loan. In addition, if
market rates fall later on, your interest rate will drop as well.
A disadvantage of ARMs is that they can be unpredictable.
You should always be prepared for increasing interest rates, especially given
the historically low rates of the past several years. This can be problematic
if you are on a tight budget and can only allocate a certain amount of funds
for your mortgage. Many ARMs will have limits in place on how much, and how
frequently, your rate can increase. Understand the terms of your loan and be
certain you can handle a worst-case scenario if interest rates rise.
Here’s an example: A
5/1 Libor ARM 2/2/5. A 5/1 ARM means
that the introductory rate is set for the first 5 years, and after that it
adjusts each year on the anniversary of the loan. The annual adjustment is based on an “Index”,
in this case, the 1 Year Libor plus a “Margin”.
The Libor right now is very low, around .5% and the typical margin is
2.25%, so the adjusted rate today would be 2.75% - not bad! The 2/2/5 means that the maximum first and
annual adjustment would be 2% and the lifetime maximum adjustment is 5%. So if your starting interest rate was 3%, the
maximum it could adjust to over the 30 years would be 8%.
Lenders offer 1, 3, 5, 7, and 10 year ARMS. So the period of the rate being set depends
on the type of ARM you choose. If you
purchase a home with the plan to live in that home for less than 10 years, and
ARM may be a very smart choice for you.
For more information on the difference between a fixed-rate
and an adjustable-rate mortgage or how to determine which one is the best
option for you, contact Stuart Epstein at 410.491.0200 or sepstein@baybankmd.com, your Mortgage Consultant for Life.
