Fixed rate vs. adjustable rateLatest Issue, Real Estate Thursday, October 12th, 2017
Prior to the Great Depression, mortgages were primarily short term and had to be refinanced when their terms expired. Foreclosure was common and something had to be done. The federal government took note and the fixed rate mortgage was born.
The fixed rate long term mortgages introduced were self-amortizing, that is, by the time their term expired, homeowners making consistent payments succeeded in paying off their mortgages and owning their properties free and clear. These financial instruments remained popular as they offered security, consistent payments and a clear path to loan repayment.
Fixed rate mortgages, usually designed for a term of 30 years, remained the number one choice for home buyers through the years, and in 2017, over 85 percent of all loan applications were for fixed rate loans.
Of course, lending institutions have and continue to offer options that may be more advantageous for the lender. Enter the adjustable rate loan, or ARM. As opposed to a fixed rate, an ARM has an interest rate set only for a specified period of time, after which the interest due will adjust. The introductory rate is called the initial cap; subsequent adjustments are called the periodic cap and the highest the rate can go up is called the lifetime cap.
A typical ARM may be labeled a 5/1. What that means is that the rate is fixed for the first five years and then adjusts every year after that. It’s important to read all the fine print in considering an ARM, as loan terms vary quite a bit, and the formula the rate increase is based on can be quite confusing.
Why would anyone consider an ARM then? The answer lies in the fact that ARMS offer a lower introductory interest rate than fixed rate products and this is often the key to making a purchase affordable. One of the additional reasons ARMS are back in favor is the lack of affordability of available properties. Inflated markets are largely due to lack of inventory and increased demand with the entry of millennials into the marketplace.
The lender is willing to offer the lower rate because it is betting it will make up the lost interest in the long run. For the buyer, the lower payment may be the difference he needs to qualify for a mortgage, and perhaps buy a more expensive property. The buyer is betting he will make up for the extra cost in the equity he builds. For buyers expecting to stay in the property only a few years, or upgrade to a more expensive home, the ARM actually may be a wise move.
ARMS got a bad reputation in the years prior to the most recent foreclosure crisis, when banks issued loans to unqualified borrowers. Some of these disreputable products included negative amortization ARMS where the initial payments did not even cover interest and the loan amount actually increased. These terms are no longer legal, and disclosure regulations have made the entire marketplace considerably safer for borrowers.
As with all decisions regarding real estate purchases, a word to the wise: be informed, get expert help and tailor the best deal you can for your individual circumstances and budget. Choose the fixed rate or ARM that meets your profile and means.
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