Which mortgage is better?
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Which mortgage is better?

An adjustable rate mortgage or a fixed rate mortage ...

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Which is better? An adjustable rate mortgage (ARM), fixed rate mortage (FRM) or a hybrid of the two?

Adjustable rate mortgages start out with an interest rate that is significantly lower than available fixed rate mortgages.
After the first year, ARMs can go up or down depending on prevailing interest rates in the economy. Lenders use some type of index to decide that. It could be the rates of federal government Treasury bills, the rates paid by certificates of deposit or the 11th District Cost of Funds Index (COFI). (The 11th district refers to interest paid to banks on loans in California, Arizona and Nevada.)

The lender determines what the index interest rate is. Then they add their markup, which is their margin or spread. The total of the index rate and the margin is the total interest rate you pay. Because of early abuses, lenders are now required to build in some protections for ARM mortgage holders.
There is a periodic adjustment cap, which is usually 2%. That means that your ARM's interest rate cannot be raised more than 2% at any one time. So even if the index interest rate jumps 3%, the lender can raise your mortgage's interest rate only 2%.
Plus, there're lifetime caps of usually 5-6%. So if you get an ARM of 5%, and mortgage interest rates go up to 1982 levels of 18% over the next few years, the most your mortgage's interest rate can be raised to is 11%. (And this can be done no more than 2% at a time, because of the periodic adjustment cap.)

The advantage of ARMs to consumers is that they start out paying a smaller monthly house note than they would with a fixed rate mortgage. If mortgage rates go down in the future, they will benefit from this - unlike fixed rate mortgage holders.

However, the disadvantage of ARMs to consumers is that in the future interest rates could also rise. Therefore, within a few years they could be paying more per month than they would have with a fixed rate mortgage.
(And although history is no certain predictor of the future, right now we are much closer to historical lows than to historical highs.)

There are two answers to this:

1. In the future, they will hopefully have a higher income with which to meet their mortgage obligation. Carefully consider your career expectations.

2. If they have maintained a good credit rating, they may be able to refinance to a fixed rate mortgage.

Another disadvantage of adjustable rate mortgages is that some types raise the interest but not the total amount of the monthly payment. This means that the mortgage holder is not paying off the loan's principal and is actually going further into debt.

Let's say you were paying $1000 a month - $965 in interest and $35 a month in principal.

Then the ARM's mortgage rate goes up by 2%. Suddenly you owe (for example) $1045 a month in interest. But the lender continues to require you to pay only $1000 a month. The $45 interest shortfall is added to your loan's principal balance.
Meaning that every month you owe MORE money than you did the month before - even though you're making your payments right on time! This is known as negative amortization and is obviously a bad situation for home owners. Avoid such adjustable rate mortgages. If the interest rate goes up, so should your monthly house payment. But that leads into the other trap that ARM mortgage holders can fall into.

Some people take out ARMs because that is the only way they can afford to buy the house they want. They just don't have the monthly income or credit rating to pay the cost of the higher fixed rate of interest. If their income does not go up significantly when the ARM's monthly payment goes up, they can get into real financial difficulty.

Therefore, bear in mind that you should take out an ARM mortgage only to save money on the interest rate, not to buy a house you could not otherwise afford. Otherwise, you could lose it in a year or two.

Fixed rate mortgages are exactly what they sound like - your interest rate is fixed for the life of the loan. If that's 5% at the beginning, it's 5% for the next 30 years. Fixed rate mortgages have the advantage that they remain the same no matter how much mortgage interest may go up over the life of the loan. This can be beneficial to consumers who don't want to think or worry about the ups and downs of interest rates. Some people would rather just pay one fixed rate, knowing it will never rise in 30 years even if we go back to the 18% rates we saw in 1982. And right now is historically a good time to have such an attitude. Although rates could go lower in the future, they can't go much lower. They have and could go again much higher. (Anybody who took out an 18% fixed rate mortgage in 1982 has either refinanced by now or is an idiot.)

Fixed rates are higher than adjustable rates because the lender is taking the risk that rates will go up significantly during the life of the loan.

Hybrid mortgage types start out as fixed rate mortgages, but after a period of time become adjustable rate mortgages. To consumers, hybrid mortgages offer the worst of both worlds. You start out with the higher rate of a fixed rate mortgage, but without the long term safety from interest rate hikes that a fixed rate mortgage offers.

So the real choice for consumers is between ARMs and FRMs. And which one is best for you depends upon your particular circumstances. If you plan to stay in your new home for many years, and you value the security of knowing your house payment will never go too high for you to pay - then the fixed rate mortgage is probably best for you. If you know you may be selling your home within a few years, and you value saving money right now, and you plan on keeping your credit rating high so that you can always refinance your mortgage if it becomes advantageous to do so -- then the adjustable rate mortgage is probably best for you. You should consider the worst case scenario, however. If your ARM's interest rate is raised to the maximum in a few years, could you pay that every month? If not, you better be sure you can refinance. If you absolutely need an ARM's lower monthly payment to afford the house you want to buy - you should reconsider. You are taking a big risk that in the not too distant future you will not be able to pay your monthly mortgage and will lose the house and damage your credit rating with a foreclosure.

Interest rates go up and down. The best minds in the financial world study them intensely, but nobody can predict what they'll be next month, let alone over the next 30 years. If the last 30 years is any indication, they'll range from 18% to 4% or so. But nobody really knows, and anybody who claims to know is a liar. A truly smart strategy would be to take out an ARM and invest the difference between your ARM and what a FRM would have been. Put that money into an IRA or any interest or dividend-paying investment. Whatever, you do - don't let a lender or mortgage broker make the decision for you. Go for the type of loan that best meets your financial needs. (don)
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