Many people are usually faced with deciding between a fixed rate mortgage (FRM) or an adjustable rate mortgage (ARM), and sometimes aren't sure which direction to take. This little handy guide should help you formulate your decision.
ARMs have lower payments in the early years than FRMs. But, they expose you to the risk of higher payments in future years. Select an ARM if you cannot afford the payment on an FRM, or if you confidently expect to be out of the house within 5 - 7 years. If you aren't sure if you might be out of your house within 5- 7 years, then select the FRM.
If you can afford the payments, and a) expect to have the mortgage 7 years or longer; or b) have a strong preference for payment stability, then select an FRM. Select an ARM if you cannot afford the payment on an FRM, or if you confidently expect to be out of the house within 7 years.
If I Select an ARM, Which One Should I Choose?
If you are selecting an ARM in order to make the payment affordable, try to avoid the riskiest ones with initial rate periods of less than 5 years. If you are selecting an ARM because you expect to pay off the mortgage before the initial rate period is over, leave yourself a margin for error. If you expect to be out in 6 years, for example, take a 7-year rather than a 5-year ARM.
The Options ARM (sometime referred to as Pick-A-Payment or Negative Am loans) is for borrowers who want to purchase as much house as possible, but need the flexibility in making monthly payments. Typically, this type of loan is for people who work on commissions, own their own business, or expect larger increases in income in future years such as doctors and other professionals. Options ARM loans provide the lowest initial payment of any ARM, but also present the greatest risk of future payment increases and negative amortization.
If I Select an FRM, Which One Should I Choose?
FRMs vary by term, which is the period used to calculate the mortgage payment. FRMs range from 10 years to 40 years. The longer the term, the lower the mortgage payment but the slower you pay down the balance. I do not recommend 40-year loans because they carry a penalty rate. If you need a lower payment, I recommend that you consider the 30-year FRM with an interest-only option.
The 30-year and 15-year FRMs are the most popular by far, and the price of the 15 is always below that of the 30. The price of the 20 is usually between that of the 15 and the 30, but it is closer to the 30, and sometimes more! The 10 is usually priced a little lower than the 15, but not always.
The selection process should start with the 15 because it is the best deal around for borrowers who can afford the payment. Most of those who can't afford it opt for the 30 because the payment is substantially lower.
The 20-year term is for borrowers who want to pay off as soon as possible but can't quite make the payment on the 15 year loan. An interest-only option is not available on 15s, so that is not an option.
If you're considering a 25 or 30 year term, consider a 30 year instead and ask for the payment schedule to pay down in 25 or 30 years. Not only will you have an easier time qualifying for the 30 year mortgage, but it will give you some flexibility in payment in case you need it if you're going to pay back on a 20 or 25 year schedule.
Some borrowers who can make the payment on a 15 are persuaded to take a 30, or even a 40, in order to invest the difference in cash flow. I don't recommend this because making it pay requires a very high rate of return on investment.
East Bridgewater, MA 02333
Lew Corcoran, ASP®, IAHSP, IAHSP-CB