When you apply for a mortgage, choosing between a fixed and an adjustable-rate mortgage (ARM) loan will be one of the most important choices you make. You need to know the difference between these two loan options before buying a home so you can make the right decision about what kind of home loan makes sense for you.
Here are three big differences between fixed-rate loans and ARMs.
1. Your interest rate, monthly payments, and total borrowing costs can change with an ARM
The biggest difference between a fixed and adjustable-rate loan is right in the name. A fixed-rate loan has a fixed rate and an adjustable-rate loan has a rate that can adjust.
With the fixed-rate mortgage, your interest remains the same during your entire repayment period. It will not change. Your total payoff costs therefore also won't change, nor will your monthly payment.
With an adjustable-rate loan, on the other hand, your payments absolutely could change and so could your total borrowing costs. That's because your interest rate is linked to a financial index and can adjust upward or downward, depending upon market conditions. If rates go up, you will pay more — sometimes a lot more.
Say, for example, you borrowed $350,000 over 30 years and your initial interest rate was 5.00%. Your initial monthly payment would be $1,878.88. But if:
- Your mortgage loan adjusted after 60 months,
- There was a 12-month period between adjustments,
- You expected your rate to increase by 0.25% with each adjustment,
- And your interest rate was capped at 12.00%?
You could end up with a maximum monthly payment of $2,620.96.
You run the risk of your payment increasing significantly with an ARM, with the exact details depending on the mortgage loan you take out. You will need to carefully read the fine print to find out just how expensive your loan could get if you take this risk.
2. The starting interest rates are usually different
The starting interest rate is typically different on a fixed versus an adjustable-rate mortgage. For example, if you have a FICO® Score of between 680 and 699, the national average APR for a $300,000 30-year fixed-rate loan as of May 18, 2023 is 6.844% according to myFico. But, with that same credit score and a 7/1 ARM (an adjustable-rate loan that can begin adjusting after seven years), you'd be looking at a starting interest rate of just 4.123% as of May 18, 2023.
While you do get a lower starting rate with an ARM in most situations, remember that as mentioned above, you run a serious risk of your rate going up over time.
3. You may need more asset reserves for an ARM
Many lenders require you to have more assets in reserve when you take out an adjustable-rate mortgage. This may not be the case for a fixed-rate mortgage. This is because you are taking on that added risk of your interest rate changing. So you will need to be able to show you have extra cash if you're thinking of choosing an adjustable-rate loan.
You should carefully consider these differences and decide whether you want to take a chance on an ARM if you qualify for a lower starting rate, or if you would prefer the certainty of knowing exactly what your home loan is going to cost you over the life of the loan.
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