When you’re ready to finance your new home, you’ll need to decide between a fixed-rate and adjustable rate mortgage (ARM) and to decide the length of your loan term. While the majority of borrowers choose fixed-rate mortgages and first-time buyers in particular prefer a 30-year fixed-rate loan, there are some advantages to a shorter loan term and to an ARM.
While mortgage rates fluctuate, the interest rate on a 30-year fixed-rate loan is higher than a shorter-term fixed-rate loan, sometimes as much as one percentage point higher than a 15-year fixed-rate loan. The interest rate on a 5/1 ARM, which is fixed for the first five years and then adjusts annually, is often about one-quarter of a percentage point lower than the rate on a 15-year loan. However, the monthly payments on these loans and the amount of total interest you pay varies dramatically because of the different loan terms.
For example, on a $400,000 loan:
- 30-year fixed at 4.09% = $1,930 monthly principal and interest / total interest: $294,971
- 15-year fixed at 3.34% = $2,828 monthly principal and interest / total interest: $109,077
- 5/1 ARM at 3.21% = $1,732 principal and interest / total interest: $223,540
Pros and cons of 30-year fixed-rate loan
As you can see, the primary benefit of a 30-year fixed-rate loan is the lower payment, in this scenario, $900 less than the shorter loan term. In addition, most borrowers like knowing they have locked in their principal and interest payment for the long term so they don’t have to worry about increases.
The downside is that these loans include heavy interest payments because of the length of the loan. In the initial years of the loan, each monthly payment is mostly interest, so it takes a longer time to build equity.
Keep in mind, though, that you can always make extra payments to your principal to pay down the balance faster. Your required monthly payment won’t change, but you can pay off the loan faster with extra payments.
Pros and cons of 15-year fixed-rate loan
Many refinancing homeowners choose 15-year loans, particularly when interest rates are low, so they can build equity faster and own their home without a mortgage more quickly. Locking in a low interest rate for the long-term offers peace of mind to borrowers, too. As you can see, borrowers in this scenario can save more than $185,000 in interest payments over the life of the loan.
The downside is the monthly payment, $900 more than a 30-year fixed-rate loan. If you can comfortably afford the payment without shortchanging other financial goals such as saving for retirement, a 15-year loan builds equity and can be a good choice, but it does lock you into a higher payment for the entire loan.
Pros and cons of 5/1 ARM
Today’s hybrid ARMs include a fixed-rate period followed by annual adjustments. Unlike some of the riskier ARMs of the past, these mortgages require you to pay principal and interest and have caps on how much the loan can adjust each year and over the life of the loan.
The main advantage of a 5/1 ARM is the fact that it has a lower interest than fixed-rate loans and yet is amortized over 30 years, which means that these loans have the lowest monthly payments during the initial fixed period. In addition, because of the lower interest rate, your total interest payments could be lower than a 30-year fixed-rate loan. However, that amount could change if your adjusted interest rate increases.
The disadvantage of an ARM is that your interest rate will adjust after the first five years. For instance, a typical cap for a 5/1 ARM is 2/2/5, which means that your rate can change by a maximum of two percentage points during the first year of adjustment, a maximum of two percentage points each subsequent year and a maximum of five percentage points over the life of the loan. This means the $400,000 ARM referenced above could adjust to 5.21 percent in the sixth year and your payment would jump to $2,199 or $467 more than your initial payment. Over time, the rate could go as high as 8.21 percent for a monthly payment of $2,994 or $1,262 more than your initial payment.
For some borrowers, such as people who know they will sell their home within five years or who have a firm promise of a salary increase (such as someone about to finish law school or medical school), an ARM could be a smart choice. If you’re reaching for a house that’s slightly above your budget, an ARM could make it more affordable in those early years, but make sure you can afford the payments in later years.
Consult a lender to explore the pros and cons of each loan type for your individual circumstances.
This story originally appeared in the March/April 2017 edition of New Homes Guide. Visit our website to order your FREE copy of New Homes Guide today!