Adjustable-rate mortgages, where the interest rate is subject to change according to market fluctuations and terms, may make certain borrowers wary, particularly following the Great Recession. But there are times when this mortgage type may be right for you.
Here are some things to consider if you're looking for a short-term home loan and are on the fence about what mortgage to apply for.
ARMs vs. Fixed Rate Mortgages
The mortgage king is still the plain old 30-year, fixed-rate mortgage. The payment on this mortgage type remains constant over its 360-month life, with no changes. It's measurable and gives homeowners the ability to plan their finances around a set payment.
The 30-year fixed rate mortgage is also the most expensive mortgage. What makes the 30 year loan pricey is its 360-month term. The longer the term of a mortgage, the more interest you'll pay over time. Conversely, on a shorter loan, you pay quite a bit less in interest.
The adjustable-rate mortgage offers a teaser rate for a certain introductory period, typically in increments of 3, 5, 7 or 10 years. The loan rate becomes variable after the teaser period ends — at that point, the interest rate is based on a fully indexed rate and changes usually about once per year.
The fully indexed rate is computed by adding an index, like the 12-month London Interbank Offered Rate, to a margin, say at 2.25. These factors vary from lender to lender. However, as an example, if you took out a 5/1 ARM, the first five years could feature a teaser rate at 2.875%, while the remaining 25 years of the 30-year term would be variable.
ARMs do contain annual caps and life caps, disclosing just how much your rate and payment could go up annually and over the term of the loan.
The Current Mortgage Market
Currently, conventional 30-year fixed rate mortgages are priced at around just .5% higher in rate than a short-term adjustable-rate mortgage.
So, for instance, if you were to take a loan at $500,000 at a 30-year fixed rate of 3.875%, you could get the same loan size on a five-year ,adjustable-rate loan at 3.375%. That is a small spread between too vastly different loan types. The relationship between ARMs and 30-year fixed rate mortgages used to be about a full 1% when ARMs were much more popular.
However, rates are always subject to change. And you should look at the big picture when applying for a mortgage, especially if you are on the fence about which route to go.
When Should I Consider an ARM?
The average 30-year fixed-rate loan typically only stays on the books for about 5 to 7 years. That's because within that timeframe, many borrowers will refinance or buy another property.
If you know the loan that you'll have is going to be short-lived due to your financial circumstances, an ARM may be a suitable choice. Keep in mind, you'll generally need to be out of the ARM before the interest-rate adjustment period occurs (also called a re-cast).
The following scenarios could make an ARM worth considering:
- The property with the ARM is going to be sold within the next five years or within the teaser-rate time period.
- You're selling another property, and the net proceeds will be used to pay off the property with the ARM.
- You're using the ARM as part of an accelerated principal-balance-pay-down strategy. For instance, you could be making large, radical principal-balance pay downs on your short-term ARM. With the right teaser rate period and low rate, such a strategy could accelerate your ability to pay off your home. But this strategy would only apply for disciplined homeowners.
- You don't really need the money. If you have significant liquidity and understand the market flows, ARMs can be less costly.
Everyone's personal financial decisions are different and everyone has different reasons for needing to borrow money. If your future is unknown, a longer-term, fixed-rate loan is probably a safer bet in most circumstances. Ask questions, do your research and make sure you understand the fine print associated with whatever type of mortgage best financially suits you.
You should also check your credit before applying for a mortgage since a good credit score generally entitles you to lower interest rates, regardless of type. You can view your credit scores for free each month on Credit.com.
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