When it comes to buying a house, you have to make lots of decisions. You have to figure out which neighborhood you want, which school district, how much of a down payment to make, etc. One of these decisions is whether you will take out a fixed-rate or adjustable-rate mortgage.
A fixed-rate mortgage is the most common kind of mortgage. The interest rate and monthly payment (principal and interest, excluding tax and insurance) with this kind of mortgage remains the same throughout the life of the loan.
Adjustable-rate mortgages will start off with lower interest rate than comparable fixed-rate mortgages. But the interest rate of an ARM can change. When it does, the payment will go up if market rates are going up, and down if rates are dropping. There are caps that limit how much your payment can change, but some people experience “payment shock” when mortgage payments rise. If you choose an ARM, make sure you understand how high your payments could go.
Hybrid mortgages, as the name suggests, give you a mix of both types of mortgage. Specifically, you’ll start with a fixed rate for a set time (often five, seven or 10 years). For that initial period, you will know for certain what your principal and interest payments will be. When that time is up, your mortgage rate can change, generally adjusting annually. If a mortgage is called a “5/1 ARM,” that means it has a fixed rate for five years, and that it adjusts once a year after that.
Which Mortgage to Choose
As with so many personal finance questions, the type of mortgage that’s right for you depends very much on your situation. The standard advice is if you plan on living in your home for only a few years, you might want to think about an ARM or hybrid. You would save money because the interest rate for the ARM would be lower during those initial years than the fixed rate mortgage.
Of course, as the recent recession and housing crisis taught us, you can’t always sell a house when you want to. So if you choose an ARM, you need to be prepared to pay the maximum allowable interest rate. Fixed-rate mortgages offer the security of knowing your principal and interest payments will be the same for the life of the loan. If rates increase, you don’t need to worry about it; if they decrease, you can consider refinancing. You can also refinance from an ARM to a fixed-rate mortgage to lock in a lower interest rate for the longer term.
Should You Refinance?
So let’s say you are in that very position – with an adjustable-rate mortgage, thinking about refinancing to lock in a lower interest rate. Interest rates aren’t as low as they were a short time ago, but they are still in historically low territory. But there are some things to consider – the rate (and limits) of your current loan, the value of your home, your equity in the home and the current interest rate. There are significant upfront costs when it comes to refinancing (you’ll pay closing costs), so if you plan to sell your house soon, it might not be the best decision. Ultimately, you have to look at your individual situation and financial goals to determine if refinancing to switch from an ARM to a fixed-rate mortgage makes sense for you.
More from Credit.com