Adjustable Rate Vs. Fixed Rate Mortgage Loans: Locking In On the Best Deal

You clicked on this page to find out one thing – whether you should choose a fixed rate mortgage or an adjustable rate mortgage (ARM). Instead of giving you complicated definitions, let's discuss the top two questions you need to answer before making your choice.

The biggest mistake most people make is to wait until after they find a home to decide whether they can afford it. By that point, they're committed to a house and will do almost anything to get it. So, instead of letting you make that mistake, I want you to answer a few questions first.

The Important Questions

How long do you expect to stay in the home? I know, it's a hard question, and I don't expect you to be a fortune teller. But, think about it realistically. If you're moving for the school district, how long will your kids be in school? How long do you think you'll stay at the same job?

How much can you afford to pay monthly for your home? Don't give the ideal answer that's $ 200 more than you can currently pay per month. Be completely honest with yourself. If that means you need to go in reverse and make a monthly budget, do it. Just make sure your budget includes some money that goes into savings every month so that when there's an emergency, you'll be ready for it.

The Basics

Fixed rate mortgages – the name says it all. You get a fixed rate that stays the same for the life of the loan, usually 15 or 30 years. Although your interest rate will be a little higher than with an ARM, you will know exactly how much you'll pay per month for a few decades. If you love stability, this loan is probably for you. Also when interest rates are low, this is the loan that lets you cash in for years to come.

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ARMs, on the other hand, are anything but stable. These loans generally have a lower initial interest rate than fixed rate loans (usually around 2% less). This initial teaser rate usually lasts anywhere from 1 to 10 years. You'll know it's an ARM when you see 3/1, 5/1, 10/1; respectively, these are 3, 5, and 10 year fixed rates. After the set time, the rate varies based on a standard, usually the Treasury Bond rate. The rate can change monthly or yearly, but yearly changes usually work out best for the consumer.

Although we're not going to talk about them here, there are several types of hybrid loans that can give you the best of both worlds. To find out more about those, check out this article from The Motley Fool, "Your Choice of Mortgage: Basics and Variations."

Let's Look at Your Answers

Now that we're through with the basics, let's talk about your answers. These are the most important questions you need to answer before shopping for a house. Did you catch that? Not before you look for a lender. Not before you hear what your monthly payment will be. Before you shop. Otherwise, you may want a house so badly that you'll be willing to do anything to get it. These answers will not only help you decide on a loan, but they'll also help you choose a home.

Time in the Home

How long do you expect to stay in the home? Five, ten, twenty years? If you plan to stay in the home more than ten years and interest rates are low, you want to choose a fixed rate loan. The payment will be lower, and you can budget for the next thirty years, though it's really more practical to choose a 15 year loan and save yourself thousands in interest.

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If you answered ten or fewer years, you may want to choose an ARM. Generally, ARMs are available up to 10/1, which means that you pay the fixed rate for 10 years and then it becomes adjustable. The good news is that if you move before those ten years are up, then you will have saved money. If you discover you'll be in the house longer, refinance when interest rates are low so that you can get a fixed rate loan. Also, if you can find a reasonable 10/1 and rates are high, you should probably take it since rates will probably fall within the next 10 years.

Monthly Payment

This is the single most important issue when purchasing a home. If you can't afford the monthly payment now, then don't assume you'll be able to afford it later. Before shopping, decide how much you can pay and commit to sticking with that number no matter what.

If interest rates are low, lock into the savings with a fixed rate loan. If rates are extremely high, try to get a 5/1 or preferably a 10/1 ARM. When rates drop in that five to ten year span, refinance at a fixed rate.

ARMs have a cap on the rate, so before purchasing a home, calculate the highest possible monthly payment based on the cap and decide whether you could make the payment if rates went up. If not, you'll need to hope for low rates so that you can refinance or simply choose a fixed rate loan.

The Bottom Line

The bottom line is to get the best deal you can right now and for the next ten years. Interest rates make a full swing about every decade. If you can save money with a 10/1 and you are pretty sure rates will drop during the first ten years, go ahead, choose the ARM, and refinance when rates are low. Remember to stay within your budget no matter what, and be prepared to refinance someday if you really want the best deal.

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