Mortgages: Fixed Rate vs Adjustable Rate

While shopping for a mortgage, you will need to decide whether to take a fixed-rate mortgage or an adjustable rate mortgage (ARM).

As the name implies, the interest-rate of a fixed-rate mortgage will remain the same throughout the life of the loan. If interest rates are low when you are buying or refinancing a home, a fixed-rate mortgage is a good choice, because you can lock in a low interest rate. ARMs, however, will fluctuate as interest rates rise and fall. Your 6 percent rate today could drop to 5 percent next year or end up at 8 percent if the market rate goes up.

Exactly when the rate of your ARM loan will change depends upon the terms of your loan agreement, which could see rates change every three months, once a year, every three years, or every five years. It's not uncommon to find ARMs that start at a fixed rate and convert to an adjustable rate after several years.

ARMs also generally come with a "cap," which limits the amount a lender can raise its rate. The cap for most ARMs is 2 percent, meaning a lender can only increase its rate 2 percent within a single adjustment period. But several adjustments can turn a 4 percent interest rate at the beginning of the loan into a 10 percent interest rate later on.

As you might imagine, fixed-rate mortgages are more popular. Most home buyers want the security of knowing how much their mortgage will be each month. A fixed-rate mortgage will allow you to more easily manage your monthly and yearly budget. If you have a fixed-rate mortgage and rates do drop, you can always refinance.

Which type of mortgage is right for you? Basically, it comes down to two factors:

1. How comfortable you are with risk 
2. How long you plan to live in the house

Clearly ARMs are riskier than fixed-rate mortgages. But taking on more risk may result in a lower rate — at least temporarily. But if you plan on staying in the house for a long time, an ARM can be particularly risky — and potentially confusing — since rates will fluctuate many times over and there will be more adjustments. Conversely, if you plan to move after five or six years, you could take a 5/1 ARM, meaning the first five years are locked in (at a low rate) and it converts to an adjustable rate after that -right about the time you plan to sell.

Source: longislandrealestate4buyers.com