(NewsNation) — As interest rates begin to fall, interest in buying a home rises. And that leads to a choice that nearly every home buyer faces. Do you take out a mortgage with a fixed interest rate or one that adjusts over time? Here’s what you should know about each.
What is a fixed-rate mortgage?
Most home buyers choose a fixed rate, which means your monthly bill (excluding changes in taxes, insurance, HOA, etc.) is constant. If you plan on staying in that house for a long time, the initially challenging monthly payment becomes easier over time as your income grows.
What is the advantage of a fixed-rate mortgage?
Fixed-rate mortgages are simpler, dependable and less stressful transactions. And, if interest rates fall, you can refinance to achieve a lower monthly bill.
What is an adjustable-rate mortgage (ARM)?
An adjustable-rate mortgage typically has a lower introductory rate, which adjusts (usually up) after a certain period.
A 5/1 ARM, for example, would start at a rate lower than a fixed rate, adjust after five years, then adjust again every year.
What is the advantage of an ARM?
A lower initial rate allows some borrowers who can’t afford the monthly payment of a higher fixed rate to buy a home. As with a fixed-rate mortgage, borrowers can refinance if interest rates go down.
An ARM may also be a better choice for those who don’t plan on being in that home for a long time. Even if it’s a year or two after the initial rate expires before moving, the initial savings may outweigh the cost of the higher rate.
Why do ARMs get a bad rap?
It’s the legacy of the Great Recession of 2008. And it wasn’t about the adjustable-rate loans. It was about who was getting them and why.
Lenders started bundling mortgages into packages that were sold to third-party investors, which made the lenders a profit and eliminated their risk.
Fueled by the pressure to increase sales of mortgage-backed securities, lenders lowered the bar for borrowers and began writing “stated income” loans. That allowed borrowers to overstate their incomes to qualify for a larger mortgage.
Those adjustable-rate “subprime” mortgages had very low initial “teaser” interest rates. When the initial rate reset and borrowers couldn’t make the payments, delinquencies skyrocketed. That made those mortgage-backed securities almost worthless and triggered the economy’s freefall.
What’s the status of ARMs today?
Since then, the government established rules requiring lenders to qualify borrowers at the highest possible rate for the first five years of a loan. Also, lenders now require some form of income documentation like pay stubs and bank statements.
Experts say an ARM is back to being a reasonable alternative to a fixed rate mortgage, but you should ask a lot of questions up front, like how soon the rate would go up, what is the cap on rate changes, and just how high could the mortgage rate ultimately reach.