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Whether you are buying a new home or planning to refinance, you may be asking the question – Adjustable Rate Mortgage (ARM) or Fixed mortgage rate – which one is better? When you are trying to make a decision on whether to take an Adjustable Rate Mortgage or a Fixed Rate, you should consider two factors:
- How long do you plan to stay in the property?
- What is the difference in the interest rate between an ARM & a Fixed?
Let me elaborate this:
Rates on ARMs are usually lower than fixed-rate loans. But the rates are fixed only for 5, 7, or 10 years. So if you do plan to live in your house for more than that period, you may risk your mortgage adjusting into a very high rate prevalent at that time. However, if the current interest rate difference is substantial you may still want to take the risk.
This chart assumes a $400,000 loan, the fixed rate is at 3.25%, while for a 7 year ARM the start rate is 2.5%. In the first 7 years, you would have saved $13,440 in monthly payments on an ARM loan. Assume, the rate on the ARM adjusts to 4.5% after 7 years and stays at the same rate (i.e. 4.5%) for the next 23 years. In that case, if you chose the loan for 30 years Fixed-rate, you would have saved $38,724 in mortgage payments.
As you can see in the example if you were to keep the house for only 7 years it absolutely made sense to get an ARM. However, if you kept the loan for 30 years the fixed-rate option made more sense. So make sure you factor in both aspects mentioned at the beginning of the post before deciding on what kind of loan program works better for you.
Sometimes, even if you plan to keep the home for a longer period an Adjustable Rate might make more sense. You can benefit by taking an initial lower rate and use the saving to pay down the principal balance faster thus lowering your interest cost. You still get 5, 7, or 10 years (depending on the adjustable period of the ARM) to potentially refinance. At that time, you can even choose to lower the term of the loan to a 15 or a 20-year fixed-rate mortgage.
Discuss your situation with your loan officer who can help you with these calculations. At InstaMortgage, one of our loan officers can help you with that.
CFPB publishes an Adjustable Rate Mortgage (ARM) consumer handbook that you can download here.