If we pay so much importance to trying on shoes before we buy them to make sure they fit, we should pay all the more attention to loans. “Trying on” various loan types means shopping around, comparing and negotiating until you find the mortgage that best suits your lifestyle and budget. The large diversity of loans and the abundance of information sometimes overwhelms the borrower who’d be happy to keep it simple and easy-going.
By far, a favorite loan type is the fixed-rate mortgage or FRM, where you pay the same interest rate for the full extent of the loan. The duration for most fixed-rate loans is between 15 and 30 years. And 75% of homes are purchased using this type of mortgage. The alternative to a fixed-interest rate is the adjustable-rate mortgage or ARM, where the interest rate fluctuates at various intervals depending on different market factors.
People who prefer an ARM over an FRM, are usually attracted by the lower interest rate during the first years of the loan. It’s like choosing coffee over cocoa. Coffee is intensely flavored, but it can give you a headache. The same thing happens with an ARM: despite the lower payment in the first part of the loan, the interest rate will eventually increase. On the long run, an ARM is unpredictable and more difficult to budget.
Taking advantage of a low interest rate!
After the economic crisis of former years, the interest rates are very low and fixed-rate mortgages are considered the best choice. For families with a stable or increasing income, with 2 or 3 kids, a home to own for at least ten years represents a great purchase. Lots of people plan on selling their home only when retiring, to enjoy a comfortable life in a place of their choice.
People can now qualify for loans with a fixed rate of less than 4%, which is the minimum in the history. And they will pay the same amount for as long as the loan exists. Today’s money borrowing conditions seem like a financial “luxury resort” if we compare them to the rates back in the 1990s and early 2000s, when the rates ranged between 7% and 9%. If we look even further back, in the 1980s, the double-digit interest rates that people were paying then, are a real nightmare.
People who fell ‘victims’ to the high-rate in the 1980s, 1990s or early 2000s often encourage friends and family to benefit from the incredible low rates available now, and use a FRM for home purchase.
Fixed or adjustable rate?
With an ARM (adjustable-rate mortgage), the borrower enjoys a convenient low fixed-rate for several years. Then, the loan continues with a new rate calculated based on market conditions. There will follow periodical adjustments from then on, for the rest of the loan existence. The new interest rate depends on some specific indexes, also known as economic indicators. Several such indexes include the Constant Maturity Index (CMI), the London Interbank Offered Rate (LIBOR), the prime rate, treasury bills etc. The indexes that affect the loan should be specifically mentioned in the loan agreement.
Making your loan decision on a subjective perception that you will pay a low amount during the first 5 or even 10 years, is like wearing horse glasses. This means that you are looking in one direction only. An unusually low rate in the first years will then be replaced by an equally unusual high rate at the end of this “vanilla” period. Ask yourself this question: “how much can the rate rise after loan reset?”
Home buyers who don’t expect to stay in a house for too long could benefit most from an ARM. They have a home of their own, and they pay a very low rate for it. Buying an ARM on the sole assumption that the family income will increase at some point in the future, is tricky. Trouble (i.e. foreclosure) is just around the corner if the income drops, instead of increasing.
The unpredictability of adjustable-rate loans is their big issue. It proves a challenge to build a long-term financial plan. If you need real stability with your mortgage, fixed-rate loans are the safer option because the payment remains the same.
Although they are a bit more costly in the first years of repayment, fixed-rate mortgages have a large number of benefits.
- You can keep your financial “world” simple: no worries about changes in the interest rate, no calculations of the rate, no problem about rate structure and no questions about the loan going into negative amortization or not.
- Borrowers enjoy more stability and security. FRM makes an excellent choice for first-time homeowners.
- Fixed-rate loans allow people to plan their finances easily, knowing exactly the amount of monthly expenses. This is also a suitable solution for people who intend to keep their home for a long period of time.
- Inflation does not affect fixed-rate mortgages. You can buy less for your buck when inflation kicks in and prices skyrocket. In fact, in times of inflation (i.e. a lower dollar value), you pay less on your loan.
- Some people prepay the principal on the FRM when the interest rates are low. Paying down a mortgage when the rate is low, equals saving money in the interest. This is a financial step that could reduce the strain on your monthly finances, in the near future. It all depends on whether you afford it or not.
The shortcomings of fixed-rate mortgages
Despite the above mentioned advantages, it would be a mistake to believe that fixed-rate mortgages are a chocolate cake. There are downsides to every loan, and you should be aware of them before rushing into a 30-year debt.
- On a short-term, fixed-rate mortgages have higher interest rates than ARMs. Even so, the ARMs, despite the low-rate early on the loan, will get adjusted to a higher rate. And then the comparison cannot stand with an FRM.
- During the first years of repayment, you will get more money out of your pocket than you would on an adjustable-rate mortgage.
- They are less flexible than ARMs.
- Due to the higher interest rate of the first years, you may not qualify because of budget constraints. You will thus qualify for a lower loan amount than you would qualify for with a ARM. Certain limitations of ARMs flexibility are in effect since the beginning of 2014.
Which mortgage is right?
Lots of people feel at a loss when it comes to deciding which type of loan is suitable for them.
You may think that you don’t know where you will be in 10 or 15 years from now. Although that is true, planning ahead and following a certain direction in life, defines human behavior. If you just intend to keep the house for 3 or 5 years, an adjustable-rate loan seems like a good choice, because you won’t block your money in the residence. However, if you plan to stay in the same home for more than 10 years, you should definitely consider the benefits of a fixed-rate mortgage.
Lots of people go for an ARM at first, to enjoy the low rates, and then refinance when the time comes for loan adjustment. Nevertheless, this is a very risky trick and the very reason why so many borrowers went into foreclosure when the mortgage crisis broke out in 2008. The home values plunged and owners had no ability to refinance. They remained trapped with a very high rate which they were not able to pay.
Adjustable-rate mortgages could also make a suitable option for people who don’t have regular income. This is the case with people working on commission or with small business owners. It is easier to manage low monthly payments than higher fixed rates. When the borrower gets a larger sum of money, they can make an additional payment to the mortgage principle.
How much risk are you willing to take? This is the final question you need to answer. If you are keen on stability, an ARM is not a good choice for you. Lots of people choose a fixed-rate mortgage just because they know exactly what amount they need to pay. It’s ultimately a personal choice and stability or ease of mind matters greatly.