The process of buying a home is full of decisions: fun decisions, exciting decisions … often stressful decisions. It’s a good idea to go into the process knowing the answers to as many of the big details as possible, like how much you’re comfortable spending and how long you think you’ll stay in the home. A decision that goes hand in hand is what kind of mortgage you’d like to take out: a fixed rate or adjustable rate.
Many people only consider fixed-rate mortgage loans, typically 30 years in length. Homebuyers who take on a fixed-rate mortgage know what the payments will be for the life of the loan, and even if interest rates happen to rise, they are still sitting pretty for the long haul if they’ve locked in at a lower rate. But in an era where home prices are soaring, adjustable rate mortgages, or ARMs, have been gaining a foothold. ARMs typically have a lower interest rate than 30-year fixed mortgages, but are more risky — they earned a bad reputation during the housing bubble crisis— because the interest rate varies throughout the life of the loan.
Normally, the initial interest rate for an APR is fixed for a period of time, typically five or seven years, after which it resets periodically, often every year or even monthly. The interest rate resets based on a benchmark or index plus an additional spread (called an ARM margin). Once the loan starts resetting, the rate can either rise or fall, depending on market conditions.
When interest rates are low, ARMs are less popular than fixed-rate mortgages. Getting locked in at a low rate for the next 30 years helps forecast your cash flow and reach other financial goals. When the opposite is true, borrowers prefer to risk a higher rate in the future in exchange for reduced interest payments now, which supports why ARMs can provide an advantage on large mortgages. Depending on a home-buyer’s situation, ARMs can be a good call, especially for those who see themselves moving within five to seven years. As of Sept. 7, 2018, the average rate for the benchmark 30-year fixed mortgage was 4.42 percent, and the average rate on a 5/1 ARM was 4.12 percent (BankRate).
At Willow Planning Group, we’ve seen such a focus on fixed-rate mortgages that sometimes our clients aren’t even exploring the possibility of an ARM. It’s true that there are a lot more factors to consider with an ARM, but they could add up to a big difference for your bottom line. It’s worth at least exploring, and doing the projections year after year for both types of loans, because you never know which could benefit your personal situation more. On some loans even a half-percent better rate can make a very large difference. You could put that extra half-percent toward the mortgage itself — and if you do that for five years you’re that much ahead on the mortgage.
And if a homebuyer does take on an ARM, and the 5 or 7 year mark is approaching, stay on top of the rates and consider refinancing for new mortgage terms.
If you are trying decide what type of mortgage might be the right fit for you, or if you want to learn more about what’s best for your personal situation, talk with a fee-only CERTIFIED FINANCIAL PLANNER™. Your financial planner will have your best interest in mind and can help you protect your income based on your needs, values and financial goals.
Kelly Luethje is a CERTIFIED FINANCIAL PLANNER™ professional and founder of Willow Planning Group, LLC. She provides financial education and guidance to help you live life on your terms. Kelly can usually be found on a mountain, or by a lake, working virtually with clients across the country.