The recent shortage of homes for sale – and bidding wars over the few homes that hit the market – can create a sense of uncertainty for buyers.
House prices are almost 20% more than they were a year ago, and mortgage rates reflect the current real estate market. However, buyers still have the option to lock in to historically low interest rates on their mortgages.
While cash sales are about 36% In the market, most homes are bought with mortgages. If you are looking to buy a home with the help of a mortgage, it is important to determine whether a fixed rate or variable rate mortgage is better.
Much like the homes themselves, the right mortgage for you will depend on your needs and your particular situation. Often, it depends on your risk aversion and how long you plan to stay home.
Fixed rate mortgages
A fixed rate means there is no variability in the amount of interest you owe, and predictability is great for cash flow planning purposes. Even if the interest rate environment changes and mortgage rates start to rise, yours will get stuck.
This makes a fixed rate mortgage a great choice for those on a fixed income, on a tight budget, or who just don’t have a high tolerance for financial risk. You know what you’re getting into and if you can afford the monthly payments.
Of course, a fixed rate mortgage has its downsides, as interest rates in the wider market don’t just go up. If mortgage interest rates drop, yours get stuck. This could leave you with a more expensive loan than a newer mortgage.
People often think they can just refinance if this happens. Sometimes that’s a good option. Corn it’s not always worth refinancing, so this is not an infallible solution.
But ultimately, the predictability of having the same monthly payments over the life of the loan makes a fixed rate mortgage a very popular choice among home buyers.
Variable Rate Mortgages (ARM)
A variable rate mortgage (also called an ARM) is a loan whose interest rate is essentially the opposite of the fixed rate: the rate periodically adjusts based on changes in market interest rates.
The amount of monthly principal you owe on the loan usually doesn’t change except when you pay it off. The term, or the length of the loan, does not adjust either. The interest rate is the only item that is subject to external forces beyond your control, which cause it to go up or down, and which has an impact on your total monthly payment.
Most ARM rates adjust on an annual basis, although some adjust more frequently. (Other periods may include monthly, quarterly, or semi-annual adjustments.) An arm.
The initial rate on an ARM is usually set using an agreed rate or index, such as LIBOR or the Treasury index. The lender may also add a certain mark-up amount as a fee to provide you with the money in the first place.
While it may appear that an ARM is a risk for only a potential reward, the terms of the contract can make it a calculated risk where you are not subject to the whims of the mortgage interest rate gods.
For example, most ARMs include an interest rate cap in the terms of the contract. The caps limit the amount of interest rate adjustments, both upward and downward. An ARM contract can also specify a lifetime cap, which indicates that an interest rate does not go above or below certain percentages.
Be aware, however, that if you have an ARM that caps your monthly payment amount, the interest you owe may be added to the principal itself.
Let’s say you pay less than the accrued interest rate due to a monthly payment cap. But then the interest rate goes up and your payment would go over the cap. You don’t come away entirely unscathed; the unpaid interest simply becomes part of the overall loan. This increases your balance even though you have made your monthly payments.
Traditional MRAs can be beneficial for buyers if certain elements fall into place. The initial interest rate for an ARM is usually lower than that of a fixed rate mortgage, which can help you save money on your loan – at first.
The initial rate is also called the âteaser rateâ for a reason: it is subject to change during the first adjustment period, and often increases.
People with a very flexible budget may find the teaser rate worth the risk of an interest rate hike. It may also be a good idea to get an ARM and take advantage of a lower initial interest rate if you don’t plan to live in the house for very long.
Most people who use a conventional ARM do so with the intention of refinancing or selling the property within a few years. But there is another type of ARM option that might make more sense as it could still give you that option with a little less risk of sticking to a high interest rate.
Variable rate hybrid mortgages
While fixed rate mortgages and ARMs are the most common, hybrid ARMs may offer a âbest of both worldsâ solution for some homebuyers.
Hybrid ARMs start with a fixed interest rate for a certain period (usually one to ten years) before evolving into a traditional ARM contract. The longer the initial term, the higher the interest rate for that period.
The initial fixed interest rate is always generally lower than that of a traditional fixed rate mortgage, but the starting rate for hybrid ARMs is generally not as low as that of conventional ARMs.
Hybrid ARMs work well for people who expect to earn higher income in the future, but want to find a way to get a more affordable mortgage payment in the short term. It is very common when people move from their first home to their second home. The idea is that you take advantage of the lower temporary fixed rate until you can refinance into a fixed rate mortgage at a later date.
This is an especially important concept when buying a home in a competitive market. When looking for a home in a sellers market, you can easily find yourself stretching your budget to buy the home you want. The lower initial rate of a hybrid ARM can help you buy a more expensive home – as long as you can sell or refinance before the âadjustableâ part kicks in and you risk seeing your variable rate increase.
Choosing the right mortgage
If you are risk averse and seek simplicity, a fixed rate mortgage is probably the best option. However, if you are willing to take a little more risk then maybe some type of MRA (conventional or hybrid) could work for you. Your personal circumstances and goals will also help dictate the right choice.
When assessing the risk spectrum of mortgages, it’s important to understand whether the interest rate savings are large enough to justify taking the additional risk of a hybrid or traditional ARM. The difference between locking in a rate 0.25 percentage point lower is much less significant than getting a rate one percentage point lower.
Not everyone is equally comfortable with risk. Determine which option really fits your lifestyle before making a decision on what type of home loan you are taking out from a lender.