If you’ve ever purchased a home, you’d probably agree that the buying process can be complex and frustrating.
You’re given all kinds of paperwork, most of which you don’t understand, and you’re asked to sign it.
Anxious to move forward and get the keys to your new home, you sign away, not really considering the pros and cons of different options you may have.
One of those things you may be overlooking is the type of rate and loan you get.
When I got my first mortgage, the lender didn’t even mention adjustable rate mortgages to me. And this was in 2007, just before the Great Recession—when they were giving those mortgages out like candy on Halloween.
In any regard, both fixed and adjustable rate mortgages are still viable options for homebuyers. In this article, I’ll review both and do an overview of mortgage rates in general. This way you can know what option suits you best when you sit down to sign those papers next time.
Fixed rate vs. adjustable rate mortgage
The key difference between a fixed rate and an adjustable rate mortgage is that with a fixed rate mortgage, your rate is locked for the life of the loan and will never change. With an adjustable rate mortgage (also called an ARM), the rate may fluctuate either down or up over time.
To really understand the difference, though, let’s look at some of the pros and cons of each.
The economy won’t affect your rate
With a fixed rate mortgage, your rate and your payment will always be the same. The nice thing here is that regardless of what is happening in the economy around us, you’ll have security in knowing exactly what your next mortgage payment will be.
For example, major economic situations such as a presidential election can impact mortgage rates significantly (I know because this happened to me). With a fixed rate mortgage, you don’t have to even blink an eye at what will happen to your rate.
Budgeting becomes easier
This makes it much easier to budget as well. If you know precisely how much your mortgage payment will be over the next 30 years (assuming you take a 30-year mortgage), then you can plan pretty far ahead with your finances.
I have a friend who forecasts his future earning and future debt up to 15 or 20 years. It might sound crazy, but if you can keep something like a housing payment constant, you can project when you’ll pay it off and when you’ll have that money back into your budget.
It can be difficult to refinance
On the downside, fixed-rate mortgages can be a pain to refinance if and when rates do drop. Unlike an ARM, you’ll have to go through the process of having your home reappraised and qualify for a new loan at a new rate before you can take advantage of lower global rates.
Not only does this cause a headache, but it can cost a significant amount of money. I just recently moved and it cost me thousands of dollars just to close the loan.
Adjustable rate mortgages
Your rate will be lower at the beginning of the loan
An adjustable rate mortgage has plenty of benefits for the right people. First and foremost, your rate and payment will be much lower at the beginning of the loan. This has so many benefits. If you’re saving money on your mortgage payment, even if it’s just for five years, that’s still five years you can put that extra money toward something else—like a college savings account or a retirement investment account.
It’s great for those who may earn more in the future
Those who are planning to earn more in the future might also find value in an ARM. Because your payment and rate are much lower up front, you have the ability to get into a more expensive home from the onset.
Now, I’m not advocating for living beyond your means, but there are situations that would call for this. If, for example, you’re in medical school and want to buy a home in Seattle (one of the fastest growing an unaffordable markets in the country) during your residency when you’re making very little money (knowing the money is coming in a few years), an ARM might make sense for you.
Rates are unpredictable
There are also significant downsides to an adjustable rate mortgage. The future rates are completely unpredictable. While rates have hovered around the same four to six percent over the past decade, it wasn’t long ago that rates were in the double digits.
For instance, it wasn’t until the mid-80s that the lowest mortgage rates were below 11 percent. And we didn’t consistently see rates below 6 percent until about 2002. Not knowing what the future holds, having an ARM can make some people crazy—as their rate could double in a matter of years.
ARMs are complicated
Because of this, it’s difficult to budget (or sleep at night). ARMs are also very complicated. For example, an ARM is what’s called a negative amortization loan. Because the payment is so low, most of that payment is interest. That interest compounds onto the original balance and, over time, you might end up owing more than you originally borrowed. Crazy, right?
Which one is better?
From the sound of it—it seems like fixed-rate mortgages are better, right?
The answer is: it depends. Everyone has unique needs and each mortgage type benefits a different type of person.
Here are some example situations of someone who would benefit from both types.
Long-term play: Fixed-rate mortgage
If you buy your dream home in an area you never want to leave, and you like to plan ahead, a fixed rate mortgage would be an excellent choice.
A relative of mine was born and raised in our town. They’ve lived in different homes around the city, but ultimately they’ll never leave the area. They know this and are positive about staying. They’re also planners who don’t like (or need) any surprises. And they just purchased a home in the area with a fixed-rate mortgage.
To me, this is an ideal situation. They won’t have any surprises with their rate fluctuating, and they’re okay paying a little money out of pocket to refinance if rates get that much lower. They also have the security of knowing their rate and payment won’t change for the duration of their loan.
The fixed-rate mortgage was also much less complicated to them, so the home buying process was much easier. So if you’re planning to stay put and want to avoid surprises, consider a fixed-rate mortgage.
Short-term situation: ARM
If you are moving to a new home and you know for a fact you’ll be moving (and you’re certain you can sell the home), then I would consider an ARM.
Now, there are a lot of uncertainties in the future, but if you’re willing to assume the risk, an ARM could save you thousands of dollars. A great example of this is someone who is on a temporary assignment for work. I have a friend who just relocated to Los Angeles to do a three-year management program. The program ends after three years and he’ll come back to the eastern part of the United States when it’s over. Yes, there’s always a chance he stays and takes another job, leaves that job and works somewhere else in LA, or loses his job, but those are normal risks that we just can’t plan for.
So on paper, it makes sense for him to get an ARM if he’s going to purchase a home. A 3/1 arm would be ideal since he’s only there for three years. This means after three years the rate will increase. Being that he’s in Los Angeles, he feels confident that he will be able to re-sell the home in a few years (and probably at a significant profit) so in this case, it makes sense.
What are mortgage points?
Buying mortgage points is basically paying money up front to reduce your rate. Mortgage points are fees that you pay directly to the lender at the time your loan is in closing. In return, they’ll drop your rate slightly.
Buying points isn’t cheap, though. One point is equal to one percent of the amount of your mortgage. So if you have a $300,000 mortgage, buying one point would cost you $3,000 (.01 x $300,000). Buying two points would cost $6,000, and so on.
What you have to consider is how long you’ll live in the home for, how far each point knocks your rate down, and what your breakeven cost will be. So, for example, buying one point might knock your mortgage down a quarter of a percentage point. Let’s do some math to see how it works:
Say your mortgage is $300,000 and the rate you qualified for was a fixed-rate of five percent. You can buy points to reduce your rate by 0.25%. Here’s how your payment would look with three different scenarios (not including PMI, taxes, or insurance):
Scenario 1: buy no points
- Rate: 5 percent
- Points cost: $0
- Payment: $1,610
Scenario 2: buy one point
- Rate: 4.75 percent
- Points cost: $3,000
- Payment: $1,565 (+$45 savings)
Scenario 3: buy two points
- Rate: 4.50 percent
- Points cost: $6,000
- Payment: $1,520 (+$90 savings)
Now let’s calculate the breakeven point
This is the time it takes to recover the cost you paid up front with savings in your mortgage payment. To do this, you simply take the total amount paid in points and divide by the monthly savings you’re receiving. Here’s the math:
Scenario 2: $3,000 in points / $45 monthly savings = ~67 months
Scenario 3: $6,000 in points / $90 monthly savings = ~67 months
So in both scenarios, you would recover the cost of paying for points after just over five and a half years.
Buying points all depends on your unique situation. My advice would be to talk to the loan officer and get the details because every lender is different with what they offer if anything.
You might find that you’re better off not paying anything up front and instead sticking with the original rate. There are certain tax benefits for buying points, and there are unique nuances that come into play when you’re getting an ARM, so definitely do your due diligence before making any final decisions on points.
What are closing costs?
Closing costssqqttxtuaywaacsvzsurq are fees that are paid at the time of closing when you buy or sell a home (meaning that the buyer and seller both incur closing costs). While this greatly depends on the type of home you’re buying and where you’re buying it (among other factors), most buyers pay anywhere between two and five percent of the purchase price of the home at closing.
Here are some of the closing costs you might run into:
- Application fee – yes, you have to pay to apply for a mortgage. This typically includes the cost of a credit check and other fees incurred when processing a loan.
- Appraisal – before your lender will approve a loan, it wants to determine the fair market value of the property, so an appraisal will be ordered and completed.
- Attorney fee – in some states, an attorney is required to review the closing documents before a sale can be completed. A friend of mine just had this happen in New Jersey and it added about two weeks to his closing timeline.
- Closing fee – the title company wants a piece of the pie, too, and they’ll charge a fee to process the closure of the loan. This also includes them routing documents to the county to be recorded so the sale is final.
- Escrow deposits for taxes and insurance – when we bought our last home, we had to pay for six months of taxes and insurance up front, which was included in our closing costs.
- Home inspection – often this is paid for out of pocket, but it can sometimes be included in the closing costs. Before you purchase a home you’ll want to have a third-party inspection done.
- Loan origination fee – typically amounting to one percent of the loan, this is another cost many lenders will stick you with for creating the loan.
These are just some of the fees you might see on your closing documents. For a comprehensive list, check out the one Zillow put together.
Why do rates fluctuate for ARMs?
It depends on the type you have
Adjustable rate mortgages change depending on the specific type of product you have. Most ARMs now have an introductory period of a lower rate. You’ll see this as a 5/1 or 7/1 for example. That first number is the number of years you have at the introductory rate, and the second number is how often it changes after that (so you’d see a rate change once per year after the first five years). A three-year ARM, though, wouldn’t have an introductory rate period and instead, the rate would adjust once every three years.
Set by an index
Now that you have a basic understanding of how rates adjust, you should know what causes rates to fluctuate. Adjustable rate mortgages are based on some type of index, which is determined by the lender.
The index is a baseline rate set by a certain governing body. A great example of this is the Federal Reserve benchmark rate. In this case, your mortgage rate would be tied, to some degree, to the Federal Reserve benchmark rate—so if the rate went up, so would your mortgage rate. If it went down, you’d see a drop in your rate as well.
Rates are determined by the economy
What causes fluctuations in the index rates is an even more complex conversation. To read more details about this, check out this article. But basically, these rates are determined based on the economy.
For example, when we were going through the economic crisis in 2008, the Fed lowered the benchmark rate to 0. This opened up lending and borrowing as much as it could, considering the dire circumstances of the economy. As things got better, the Fed raised this rate, making it more expensive to borrow money. These factors all have an impact on your rate moving up or down when you take out an ARM.
Where to find the best rates
To find the best rates, we’ve got you covered.
- Step 1: Check out our guide on how to find the best online mortgage lenders. This will walk you through the process of vetting the best online lenders and help you decide which ones you should consider. We also suggest checking out Lending Tree to see all your rates in one place.
- Step 2: Review the best overall rates available right now on mortgages. Hopefully, some of the lenders on the list from Step 1 are on this list of best rates. If so, consider those lenders strongly.
Knowing the difference between a fixed-rate and adjustable rate mortgage is critical. If you don’t you could end up wasting thousands of dollars up front and over the course of your loan.
Remember that each type of loan will be beneficial for someone—but it really depends on your unique situation. Know the rates and do your research before committing to anything. If you’re still stuck, I’d recommend finding a financial advisor, as jumping into a 30-year loan is a significant financial commitment that could impact you down the road.