Adjustable Vs. Fixed Interest Rate Mortgages: What’s Your Type?
Matt Herz had been leasing an apartment in a south Denver suburb with his fiancée for the past three years. Now that they’ve decided to start a family, they’re drawn to Denver’s vibrant urban neighborhoods like Capitol Hill, the Highlands, and Congress.
Having found the perfect starter home, they met with a lender earlier this year to price loans. “But the monthly payments were coming in too high,” says Herz, 34.
Their broker, Cameron White at Elevations Credit Union, suggested a 7/1 adjustable-rate mortgage (ARM).
“At first I recoiled; I’d heard so many bad stories about ARMs,” says Herz. “But Cameron explained how the products work now, and we became intrigued.”
“Many buyers are predisposed to think they need a fixed-rate mortgage,” explains Tim Mislansky, chief lending officer of Wright-Patt Credit Union in Dayton, OH. “It’s what our parents did, but it’s not always the best answer today.”
For borrowers who may move in a few years and need to keep their options open, ARMs are a good option, he notes.
Regulatory changes have eliminated features like negative amortization and prepayment penalties that have given ARMs a bad rap in the past, says Mislansky.
As an engineer who’s used to working with numbers, Herz did calculations for both loan types and found the ARM (at an interest rate of 2.875 percent) would save $50 a month over what he’d been paying in rent and include his homeowner’s insurance. “It was the perfect loan for our needs.”
Fixed vs. Adjustable
That’s not to say fixed loans, which offer an interest rate that does not change over time, will go out of style any time soon.
“[Fixed loans] appeal to homeowners who will be in their homes for a while and want peace of mind that their interest rate will remain stable,” says Elizabeth Million, assistant vice president of Mortgage Lending at Elevations Credit Union.
Fixed-rate mortgages are available in multiple terms, where “terms” like 20 or 30 years are used to describe the length for which the mortgage contract is in place, she says. When the term is complete, the loan is paid in full.
Such stability comes with a price, explains Staci Titsworth, a regional manager for PNC Mortgage. “The 30-year fixed-rate is typically a higher-priced mortgage product, because the rate is guaranteed for 30 years instead of five or seven,” she says. “And time is money.”
Even fixed-rate payments can vary, points out Mislansky. “Although principal and interest payments on the loan stay the same, your taxes might increase or decrease, which would affect the amount of your payments if they’re being paid by your mortgage company from an escrow account.”
ARMs Up Close
When it comes to evaluating ARMs, four numbers are important, says Mislansky.
The first two numbers, used in the loan’s name (5/1 or 7/1 for instance), define how long the initial interest rate stays in effect on the 30-year mortgage. After that initial period, the interest rate can go up or down on a regular, say yearly, basis as indicated by the second number (one in our example).
“In effect, it becomes a one-year ARM and the rate can change every 13 months for the remaining 25 years on the loan,” says Million.
Whether it goes up or down is based on the prime rate or another rate called an index. That’s not to say it can go up or down endlessly. Consumers are protected by the other two numbers or “caps” — the annual adjustment cap and the lifetime cap.
The caps protect the borrower against “dramatic changes in interest,” says Mislansky. A typical annual cap might be 2 percent. So your loan could not adjust more than that each reset period. The lifetime cap is in effect for the entire loan term.
How’s that translate to real life? With Google expanding its Boulder, CO operations, Elevations Credit Union has seen an influx of contract workers who plan to stay four years, and want to enjoy the benefits of homeownership while they’re there.
“A 5/1 or 7/1 ARM is something for them to consider,” says Million.
Not Your Parents’ ARM
Some lenders feel ARMs are a strong option in the current market, especially for young buyers who are just contemplating their first home purchase.
“Few of us will actually live in a home for 30 years, so why should we pay more in interest?” asks Mislansky. Wright-Patt Credit Union members include military families from Wright-Patterson Air Force Base, who know they’ll relocate every three to six years. “ARM loans with longer initial terms keep their mortgage payments low,” he says. Wright-Patt is one of many credit unions that offers a 5/5 ARM, a very attractive product to its military clientele.
And if plans change — you find a new job, decide you love the location, or otherwise need to stay put — you can refinance, advises Titsworth, who herself has a 5/1 ARM.
“When my parents bought a home they thought they would be in it for 50 years; that was their plan. People in my generation are somewhere in between. Maybe we’ll stay, maybe we’ll move, maybe we’ll downsize. ARMs give us that flexibility,” says Million. “Don’t automatically discount ARMs. They can be the right option for young buyers who don’t want a long-term obligation.”
“We got this loan at just the right time,” Herz says. “It’s a sound investment in Denver’s rebounding housing market.”