Which is the better mortgage option for you: fixed or adjustable?

The low initial cost of adjustable-rate mortgages (ARMs) can be very tempting to home buyers, yet they carry a great deal of uncertainty. Fixed-rate mortgages (FRM) offer rate and payment security, but they can be more expensive.

Here are some pros and cons of ARMs and FRMs.

ARM advantages

Feature lower rates and payments early on in the loan term. Because lenders can use the lower payment when qualifying borrowers, borrowers can purchase larger homes than they otherwise could buy.

Allow borrowers to take advantage of falling rates without refinancing. Instead of having to pay a whole new set of closing costs and fees, ARM borrowers just sit back and watch their rates fall.

Help borrowers save and invest more money. Someone who has a payment that's $100 less with an ARM than with a FRM for a couple of years can save that money and earn more off it in a higher-yielding investment.

Offer a cheap way for borrowers who don't plan on living in one place for very long to buy a house.

ARM disadvantages

Rates and payments can rise significantly over the life of the loan. A 6 percent ARM can end up at 11 percent in just three years if rates rise.

A borrower's initial low rate will adjust to a level higher than the going fixed-rate level in almost every case even if rates in the economy as a whole don't change. That's because ARMs have initial fixed rates that are set artificially low.

The first adjustment can be a doozy because some annual caps don't apply to the initial change. Someone with an annual cap of 2 percent and a lifetime cap of 6 percent could theoretically see the rate shoot from 6 percent to 12 percent 12 months after closing if rates in the overall economy skyrocket.

ARMs are difficult to understand. Lenders have much more flexibility when determining margins, caps, adjustment indexes and other things, so unsophisticated borrowers can easily get confused or trapped by shady mortgage companies.

On certain ARMs, called negative amortization loans, borrowers can end up owing more money than they did at closing. That's because the payments on these loans are set so low (to make the loans even more affordable) they only cover part of the interest due. Any additional amount due gets rolled into the principal balance.

FRM advantages

Rates and payments remain constant. There won't be any surprises even if inflation surges out of control and mortgage rates head to 20 percent.

Stability makes budgeting easier. People can manage their money with more certainty because their housing outlays don't change.

Simple to understand, so they're good for first-time buyers who wouldn't know a 7/1 ARM with 2/6 caps if it hit them over the head.

FRM disadvantages

To take advantage of falling rates, FRM holders have to refinance. That means a few thousand dollars in closing costs, another trip to the title company's office and several hours spent digging up tax forms, bank statements, etc.

Can be too expensive for some borrowers, especially in high-rate environments, because there is no early-on payment and rate break.

Are virtually identical from lender to lender. While lenders keep many ARMs on their books, most financial institutions sell their FRMs into the secondary market. As a result, ARMs can be customized for individual borrowers, while most FRMs can't.

All of these things should factor into your decision between a fixed-rate mortgage and an adjustable one. But there are other important questions to answer when deciding which loan is better for you:

1. How long do you plan on staying in the home?
If you're only going to be living in the house a few years, it would make sense to take the lower-rate ARM, especially if you can get a reasonably priced 3/1 or 5/1 ARM. Your payment and rate will be low and you can build up more savings for a bigger home down the road. Plus, you'll never be exposed to huge rate adjustments because you'll be moving out before the adjustable rate period begins.

2. How frequently does the ARM adjust, and when is the adjustment made?
After the initial fixed period, most ARMs adjust every year on the anniversary of the mortgage. The new rate is actually set about 45 days before the anniversary, based on the specified index. But some adjust as frequently as every month. If that's too much volatility for you, go with a FRM.

3. What's the interest rate environment like?
When rates are relatively high, ARMs make sense because their lower initial rates allow borrowers to still reap the benefits of homeownership. The chances are fairly good that rates will fall down the road too, meaning borrowers will have a decent chance of getting lower payments even if they don't refinance. When rates are relatively low, however, FRMs make more sense. After all, 7 percent is a great rate to borrow money at for 30 years!

4. Could you still afford your monthly payment if interest rates rise significantly?
On a $150,000, 1-year adjustable-rate mortgage with 2/6 caps, your 5.75 percent ARM could end up at 11.75 percent.

Year of Arm	Rate	Monthly Payment
First Year	5.75%	$875
Second Year	7.75%	$1,075
Third Year	9.75%	$1,289
Fourth Year	11.75%	$1,514 ($639 more than first year)

 

Now, let's compare this worst-case ARM scenario to a fixed-rate mortgage:

Interest Rate during 4 years	Total Payments during 4 years
ARM:5.75% to 11.75%	$57,036
Fixed Rate: 7.75%	$51,600
Savings with FRM over 4 years: $5

In the above case, the fixed-rate mortgage costs less than the worst-case ARM scenario. Experts say when fixed mortgage rates are low, they tend to be a better deal than an ARM, even if you only plan to stay in the house for a few years.