When you’re applying for a mortgage, your interest rate can have a huge effect on your monthly payment. With home loans, there are two different ways that your interest rate can be calculated. You can either get a fixed-rate loan, where the interest rate will stay the same for the entire length of the loan, or you can get an adjustable-rate mortgage (ARM), which will vary according to market conditions.
If you’re having trouble deciding which type of loan is right for you, I’ve laid out three questions that will help make your decision easier. Read on below to learn what you need to know about the differences between these two loan types.
How long do you plan to stay in the home?
Part of the draw behind adjustable-rate loans is that they come with a low introductory interest rate period. During this period, which typically lasts anywhere from three to seven years, the interest rates that these loans offer is often lower than what you’ll find with a fixed-rate loan.
If you’re not planning on staying in your home that long, especially if you intend to move before introductory rate period is up, it may be worth looking into an ARM. In that case, you could capitalize on the low interest rate, which may give you a more manageable monthly payment or even help you qualify for a larger loan than you might otherwise.
On the other hand, if you intend to stay put for a while, a fixed-rate loan might be a better bet. After the introductory rate period is over, the interest rate on an adjustable-rate mortgage is subject to market fluctuations, meaning that your monthly payment would rise if interest rates go up. Given enough time, that’s likely to happen so many homeowners who intend to put down roots often prefer to opt for the stability and security of a fixed-rate loan.
That said, if your financial situation is good enough for you to qualify, refinancing your loan towards the end of your introductory rate period is also an option. At that point, you could essentially reset your introductory rate period by refinancing to another ARM or choose to switch to a fixed-rate option instead.
Are you comfortable with the proposed terms?
Before you sign on the dotted line, your lender will go over all the details of your loan – or its terms – with you. With a fixed-rate loan, these terms are often much simpler. Though you’ll still want to shop around to ensure you’re being given the best interest rate possible, since your payment will stay the same for the entire length of the loan, your main concern will be whether or not that payment works in your budget.
With an ARM, there’s more to consider. Not only do you have to think about whether or not the payment is doable for you now, you’ll also have to consider if the payment will still be feasible if interest rates go up in the future. To do that, you’ll need to consider the following:
- The adjustment frequency: How often you can expect your rate to adjust once your introductory rate period is over.
- Your margin: A percentage that represents the amount you’ll pay over the base interest rate available. This can often be negotiated with the lender.
- The cap rate: The limit to the size of the rate increase or decrease you’ll experience each time your rate changes.
- Your ceiling: The highest your interest rate can go over the life of the loan.
For best results, you may want to ask your lender to calculate what your monthly payment would be if interest rates hit your ceiling. This will give you a fuller picture of whether or not you’re really equipped to handle the flexibility that comes with an ARM.
What direction are interest rates heading and do they look to stay that way?
Taking a look at the direction in which current interest rates are heading can often give you some prospective on what could happen when your interest rate is set to adjust on an ARM. In times where rates have consistently been trending downward adjustable-rate mortgages tend to be more popular. When they’ve been rising, buyers tend to opt for the security of a fixed-rate loan.
However, know that interest rates can change at any time, depending on what’s happening with the economy. Just because rates may have been trending downward doesn’t mean they’ll stay that way. If you’re thinking of opting for a variable-rate loan, make sure you’re prepared to shoulder your payment regardless of what’s happening in the market.