Most people who apply for mortgages base their decision on how much they can afford while keeping costs low and manageable. Here are some things to consider if you’re looking at a shorter-term financial picture…
Fixed Rate vs. ARM
The mortgage king is still the plain old 30 year fixed rate. On such a mortgage the payment remains constant over the life of 360 months, with no changes. It’s measurable and gives homeowners the ability to plan their finances around a set payment. The 30 year fixed rate is also the most expensive mortgage type. What makes the 30 year loan pricey is the duration of the 360 term. The longer the term, the more interest you’ll pay over time. Conversely, on a shorter loan, you pay quite less in interest.
The adjustable-rate loan offers a teaser rate for a certain introductory period typically in increments of 3, 5, 7 or 10 year terms. The loan becomes a variable after the teaser period ends at which point the interest rate is based on a fully indexed rate and changes usually about once per year. The fully indexed rate is computed by adding the index like the 12 month Libor to a margin say at 2.25 (this varies from lender to lender). For example if you took out a 5/1 ARM where the first five years was a teaser rate at 2.875%, the remaining 25 years of the 30 year term is variable. ARM’s do contain both annual caps and life caps disclosing just how much your rate and payment could go up by annually and over the term of the loan.
Currently, conventional 30 year fixed rate loans are priced at just .5% higher in rate than a short-term adjustable-rate loans. If you were to take a loan at say $500,000 on a 30 year fixed rate at 3.875% you could get the same loan size on a five-year adjustable-rate loan at 3.375%. That is small spread between too vastly different loan types. The relationship between arms and 30 year money used to be about a full 1% when arms were more common. You have got to weigh in the big picture especially if you are on the fence with your decision making.
How long do you need the money for?
The average 30 year fixed-rate loan only lasts on the books 5 to 7 years. Every 5 to 7 years not all borrowers, but most will refinance or buy another property. In other words, if you know the loan that you’ll have is going to be short-lived due to some of your financial circumstances changing, an adjustable-rate loan may be a suitable choice if you’ll be out of the adjustable-rate loan before the interest-rate adjustment period occurs (also called a re-cast).
Following situations could make for makes sense adjustable-rate loan scenario:
- The property with the arm loan is going to be sold within the next five years or within the teaser rate time period.
- You’re selling another property, and the net proceeds will be used to pay off the property with the adjustable-rate loan.
- You’re using the adjustable-rate loan as part of an accelerated principal balance pay down strategy. Such an example could be making large radical principal balance pay downs on your short term arm loan. With the right teaser rate period and low rate, such strategy could accelerate your ability to pay off your home. This would be a strategy for the disciplined homeowner.
- You don’t really need the money. If you have significant liquidity and understand the market flows, historically, adjustable-rate loans are less costly mortgages dating back to the 1970s.
Everyone’s personal financial decisions are different and everyone has different reasons for needing to borrow money. If your future is unknown a longer-term fixed-rate loan is probably a safer bet in most circumstances, but not always. Ask questions and do your research and make sure you understand the fine print associated with whatever type of mortgage best financially suits you.
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