Why Fixed-Rate Mortgages Are Better than ARMs for First-Time Homebuyers
If you’re looking to buy your first home, there are several options you can explore. You could write a huge check and buy the house outright, but if you’re like most people, you’ll probably need a mortgage. When it comes to borrowing money to buy a home, loans come in a variety of sizes and with a plethora of terms.
For example, you can take out a shorter-term loan and pay off your home faster, or you can select a long-term mortgage but have smaller payments. But the major decision you’ll need to make is whether to take out a fixed-rate mortgage or an adjustable-rate mortgage (ARM) for your first-time home buy.
Both have their pros and cons, so knowing the difference between the two will help you make the best decision for your situation.
How Does a Fixed-Rate Mortgage Work?
Fixed-rate mortgages work like this:
The lender agrees to loan you a certain amount of money, based on your income and debt levels, under specific terms. These terms usually include a minimum down payment of 5 to 10% and monthly principal plus interest (P + I) payments of a set amount for the duration of the loan.
The loan duration can vary from 10 to 30 years.
The interest rate on the loan is fixed, meaning it will never change. Your P + I payment will be the same from the first month to the last month.
If you have less than a 20% down payment, you’ll be required to have mortgage insurance. Mortgage insurance ensures that if you default on your loan, the lender can get some of the monies back. The payments are folded into the loan, making your payment slightly higher.
You may also choose (or be required) to escrow your property taxes and homeowners’ insurance. These will likely vary yearly, changing your payment slightly.
What Is an Adjustable-Rate Mortgage?
An ARM is a special type of loan. The most common type, the hybrid ARM, has a fixed-rate period followed by a period where the interest rate fluctuates. The initial interest rate, sometimes referred to as the teaser rate, is usually significantly lower than the interest rate for a conventional fixed-rate loan. This is appealing to some home buyers because it means a lower payment or the possibility of getting a larger loan or a bigger home for their buck.
How Does It Adjust?
The fixed period is usually for three to ten years. When the fixed period ends, the interest rate is adjusted according to the margin and index rate. The margin is a fixed percentage that a lender set when the loan was originated and serves as the bottom for the interest rate, the lowest possible interest rate for the loan. The index percentage is based on the financial index the lender chooses to use. For example, if the lender sets a margin of four and the index determines the index rate is two, the new interest rate on the loan is 6%. The rate is adjusted according to the time set by the lender. For example, a 7/1 ARM means the interest rate is fixed for seven years and then adjusts once a year starting in year eight.
So, Which Is Better?
Fixed-rate mortgages are a safer product for first-time home buyers. Not only do they guarantee that your payment will remain within a safe price window to minimize your risk of foreclosure, but they can also age with you, no matter how long you choose to stay in your home. Fixed-rate products are also less frightening to lenders, so your mortgage insurance, should you have it, is often calculated at a lower rate.
As a first-time home buyer, you may find that you can borrow a bit easier, even if you don’t have a lot of credit or have no traditional credit lines at all. When you sell, if your fixed-rate mortgage is assumable, you can also benefit from selling that note and those terms, which are likely to be more favorable as the years go by since current trends are indicating that interest rates are rising and may continue to do so for some time.
That’s not to say ARMs aren’t helpful. In most cases, the payment during the introductory period (the 7 in the 7/1) is lower than that of a fixed-rate loan. So, if you anticipate your income increasing substantially during the introductory period, this type of loan could be a good fit for you. But they aren’t for the faint of heart: when the interest rate adjusts, especially the first time, the increase in your payment could cause serious sticker shock. If you want to stay in your home, make sure you have a plan to refinance before the rate fluctuates.
Fixed-rate mortgages offer peace of mind, while adjustable-rate mortgages are a financial roller coaster. Knowing that your payment is the same month after month is reassuring. It makes budgeting easier. When you don’t have to think, “Well, maybe we should save this bonus check just in case the interest rate on our mortgage goes up more than half a point instead of going to Hawaii for the holidays,” it makes planning the rest of your life easier. (Aloha, enjoy your trip!)
With an adjustable-rate mortgage, when your interest-rate adjustment comes around, you’re on pins and needles—you know it’s going to go up, but you don’t know how much. This is especially stressful if the loan payments are approaching the maximum amount you can comfortably afford.
Now, if you’re already in your first home and you’re planning to sell and step up to a larger home before the introductory period ends, ARMs aren’t as bad. Between any equity you’ve accumulated and the value increase caused by natural inflation, you may be able to bring enough money to your second home that the mortgage may not be as large as the first mortgage.
Then again, the smaller the loan, the smaller the payment on a fixed-rate mortgage, too. Fixed-rate mortgages just make more sense across the board, so if there is any way you can work out taking out this mortgage over an adjustable-rate mortgage, you should do so.