Buying a house is no small undertaking. It takes time and consideration--not just what house you want to buy but where you want to buy, what you can afford, and what kind of mortgage you should get.
And while we're no longer in the 2008 crisis, the US mortgage market is still confusing for new home buyers.
Here, we're helping you figure out ARM v. fixed mortgage and which one is right for you when you choose your home in the Seattle suburbs.
What is an Adjustable Rate Mortgage?
First, let's break down the basics.
An ARM (or adjustable rate mortgage) is a type of loan that bases its rate on an index, usually something like the US Treasury yield. It's often attractive to new home buyers because the initial ARM interest rate is set below the market rate on a comparable fixed rate loan.
Here's how it works.
How It Works
A 5/1 ARM, the most commonly used type of ARM, draws in buyers because the initial rate is lower than comparable mortgage loans.
Notice the keyword: initial. Adjustable rate mortgages are just what the name implies.
After the first five years at a fixed interest rate, the loan resets, which means that there is a new interest rate based on whatever index the ARM uses to set the rate. The rate is often set based on current market rates.
That rate will then stay the same until the next loan reset, which is usually a year after the first reset.
For a 30-year mortgage, that means that after the first five years, your rate will likely change every year to reflect current rates in the market.
Knowing this about ARMs, a few advantages become obvious pretty quickly.
The biggest advantage of an ARM is, of course, the lower initial interest rate. This can allow home buyers to purchase a larger home than they might otherwise have been able to afford.
And while the market can work against you, sometimes it works in your favor, and you never see it as much as with ARMs. If market rates drop, your ARM will follow, which means you're paying a lower mortgage rate for the given reset period.
That said, when the market works against you, it's going to hurt. A lot.
Because ARM rates are based on the market as a whole, rather than the ability of the individual to pay the rate, mortgage rates for this type of loan can vary widely over the lifetime of the loan.
So while you might be saving money one year, all of that money could get eaten up the following year if market rates go through the roof.
There's also a type of ARM called a negative amortization loan. These loans are attractive at the outset because the borrower can pay less than the interest charge on the loan. This creates deferred interest, which is added to the principal balance of the loan.
In other words, you could wind up owing more money on your mortgage than you did when you closed on the house.
What is a Fixed Rate Mortgage?
Then, there's a fixed rate mortgage, also called a conventional or traditional mortgage.
As you might guess, this is the type of mortgage that most home buyers get when they purchase a house and take out a mortgage. And as the name implies, your interest rate is fixed throughout the life of the loan.
How It Works
When you take out a fixed rate mortgage, the loan is generally for 80% of the mortgage amount and the buyer (you) will make a down payment of about 20%.
Fixed rate mortgages usually have a lifetime of ten, fifteen, twenty, or thirty years, which is the time you'll have to pay back the full amount of the loan.
The amount you pay each year is the same for the full duration of the loan unless you refinance your mortgage to reduce the mortgage term and get a lower monthly interest rate.
Since fixed rate mortgages are the most common mortgage type, it makes sense that they have a few key advantages that make them worthwhile.
The biggest benefit is that unlike an ARM, your interest payment remains constant throughout the life of the loan and isn't subject to shifts in the market. Because of this, you won't have to worry about your payment shooting up at a time when you can't afford to pay more.
Since the amount remains constant, it's also easier to budget for the cost of the mortgage each month. And these types of mortgages are simpler than an ARM, which is a good thing for first-time buyers who could get confused by a 5/1 ARM.
That said, the constant rate can also be one of the big disadvantages of a fixed rate mortgage.
If you want to lower your mortgage rate, you have to refinance your loan. Aside from the cost of refinancing, you have to be in a good financial position to qualify for refinancing in the first place, which isn't always possible for homeowners.
In addition, fixed rate mortgages are constant across the market. An ARM could be tailored to your individual circumstances, but a fixed rate mortgage can't, which means that the loan won't be reflective of your ability to pay.
For this reason, this type of mortgage can be too expensive for some first-time buyers since there is no rate break on the horizon.
ARM v. Fixed Mortgage
Now that you know the basics of ARM vs. fixed mortgages, the real question is: which one is right for you?
That depends on your circumstances. Here are a few factors that will help you decide.
Questions to Ask
Before you sign on the dotted line for one mortgage or another, there are a few things you should ask yourself.
What's the Current ARM/Fixed Spread?
The difference between an ARM loan and a fixed mortgage is called a spread. Basically, the spread will determine how attractive the ARM is as an option.
In general, the shorter the initial ARM period is, the lower the starting rate. So a 5-year will have a lower rate than a 7-year, and a 7-year will have a lower rate than a 10-year.
In general, if you're looking at a spread of 50 basis points (0.50%) or higher, then the savings are substantial enough that an ARM might be worth the risk.
Is Your Mortgage a Jumbo Loan?
Everyone can joke that their mortgage is a ridiculous sum. The real question is whether your mortgage is a jumbo loan--a mortgage loan that exceeds the loan size limits for your area.
What qualifies as a jumbo loan varies based on where you live, since real estate prices (and thus mortgage prices) vary widely based on what state you live in.
You do still have mortgages available if you want to borrow more than your area's limits allow, but your fixed rate pricing options are scarce. Or rather, they're there, but they may not be worth the trouble.
For an ARM, though, jumbo loans can get cheap--think 150 to 250 basis points (1.50% to 2.50%) cheaper than a fixed rate mortgage.
What's Your Timeframe?
Another important question to ask yourself if you're weighing ARM v. fixed mortgage is to think about your timeframe--how long you plan to live in your home and the number of years (realistically) before you might be able to refinance your loan.
On average, homeowners tend to own their homes for about seven years before they sell, more for older homeowners and less for younger homeowners.
In other words, most homeowners sell their home before their hypothetical ARM would begin to adjust. With a fixed rate mortgage, you're just stuck.
Candidates for an ARM
As such, you might be starting to get an idea of a good candidate for an ARM.
In general, the best candidates for an ARM are homeowners who don't plan to stay in this particular home for decades to come or anticipate that they'll probably move sometime in the next five to seven years (before the ARM begins to adjust).
The other best candidate for an ARM loan is the buyer who has (or will have) the cash to entirely pay off the loan before the new interest rate kicks in.
For example, if you're buying one home at the same time you're selling another, you can use the proceeds from the sale to pay off the ARM within the initial period.
Candidates for a Fixed Mortgage
If, on the other hand, you have a stable income that you don't expect to increase dramatically, a fixed rate mortgage is more practical.
Similarly, if you plan on living in this house for decades to come, a fixed rate mortgage is also more sensible.
The Best Mortgage Broker for You
If you know your answer to the question of ARM v. fixed mortgage, then it's time to find a mortgage broker that works for you.
Good news: you came to the right place.
We pride ourselves on being Seattle's mortgage broker. For every new mortgage we close, we donate $300 to a local charity.