Choosing a Fixed Rate or Adjustable Rate Mortgage?

Buying a home involves hundreds of decisions, from picking a neighborhood to planning new paint colors. From the point of view of your financial health, no decision is more important than the mortgage you choose. If you are a first-time homebuyer, you might find the many mortgage-related options a little intimidating. Not to worry, we’ll review the most sensible choices so that you can make an informed decision about choosing a fixed rate or adjustable rate mortgage.

How a Mortgage Works

Your mortgage is a loan you take out to pay for the purchase of a home, and the property purchased serves as collateral for the lender. You have to make a down payment, at least 3.5 percent, and the mortgage covers the rest of the purchase cost. You then pay back the mortgage in monthly installments over the loan term, which is usually 15 or 30 years, although other terms are available. If you fail to make your payments, the lender can foreclose, forcing the home to be sold to return the money they lent you.

In a plain vanilla mortgage, your monthly payments are split between principal and interest. For the first several years, the bulk of your payments are allocated to pay interest. Lenders front-load the interest payments because they want to make their profit as quickly as possible, which is understandable. That is not so bad because mortgage interest is tax deductible and many new homeowners appreciate getting the biggest deductions in the early years of ownership. In later years, the process known as amortization shifts the payment balance from interest to principal, and by the last years, very little of your payment amount goes toward interest. Your equity in your home is its current market value minus the amount you’d have to spend today to pay off the remainder of your mortgage. As we’ll soon see, some mortgages follow different amortization game plans that can have huge implications for your finances.

How Underwriting Affects Your Mortgage

Even though a mortgage is collateralized by property, lenders don’t make money by foreclosing on delinquent borrowers. They want to feel secure that you can afford your mortgage, especially after the 2008 mortgage meltdown. Lenders evaluate your loan application in a process called underwriting, in which they examine several factors, including:

• Debt to income (DTI) ratios: The front-end DTI is the ratio of housing-related debts to gross income on a monthly basis, whereas back-end DTI compares all of your monthly debt against income. Lenders generally want to see a front-end DTI not much higher than 30 percent and back-end DTI below 50 percent, but these numbers might be relaxed if other factors are strong. FHA loans usually require a maximum back-end DTI ratio of 43 percent, although a fuel-efficient home may allow you to stretch the DTI ratio to 45 percent.
• Your down payment: The more you put down, the less you’ll owe and the smaller your DTI ratio. Also, larger down payments may qualify you for a higher DTI ratio limit.
• You credit history: Lenders like when you’ve used credit in a responsible manner, as reflected in a clean payment history and a good credit score.
• Savings: A thrifty attitude certainly helps, as lenders like applicants who have been able to accumulate savings and have a conservative attitude toward using credit. If you have substantial cash reserves, you may qualify for a higher DTI ratio limit.
• Budget: It helps if your new monthly housing-related costs will be not much greater than your current ones.

The Fixed Rate Mortgage

A popular choice among homeowners is to secure a fixed rate mortgage. The interest rate of this type of mortgage, known as the annual percentage rate (APR), is set to a fixed amount and doesn’t change over the life of the loan. You know up front how much you’ll pay on the sum total of principal and interest each month, because it’s always the same number. Your monthly payments may also include other costs, the primary one being escrow. An escrow account is frequently built into you loan agreement to prepay your property taxes and possibly your mortgage and/or homeowner’s insurance. Lenders typically require you to pay for mortgage insurance until you’ve paid down 20 percent of your loan’s principal, and also require homeowner’s insurance to protect their collateral. Escrow might also include homeowner association fees and perhaps other items.

The standard, no-frills fixed rate mortgage has a 30-year term. While this spreads the payments over a long time period, it also generates more interest than would a shorter-term period of, say, 15 years. Your financial situation will usually dictate the loan term that makes the most sense. You can have the best of both worlds by taking a 30-year loan but doubling up on your payments, so that the actual term is only 15 years or less. This has the virtue of cutting down on the interest you’ll end up paying, yet give you wiggle room if your finances take a hit and you have to fall back to single monthly payments. Also, your DTI ratio may preclude you from a loan term shorter than 30 years.

Adjustable Rate Mortgages

Adjustable-rate mortgages (ARMs) feature an interest-rate that can change over time. The interest rate is fixed for a certain period, such as three, five or seven years, before it becomes adjustable. Often, ARMs provide a cap, or maximum APR, and sometimes limit the size of each rate adjustment. ARM interest rates float with prevailing rates, but you can usually expect your rate to rise immediately after the fixed rate period ends. Lenders sometimes attach low “teaser” rates to the ARM fixed rate period to induce folks to buy homes. ARM terms are expressed as the fixed period/the reset period such as 5/1 or 7/1. The reset period is the number of years (usually one) before the newest rate is applied to the mortgage in the adjustable period. For purposes of DTI calculation, lenders often add 2 percent to the initial interest rate to determine eligibility for 3/1 and 5/1 ARMs, but not for 7/1 loans.

The biggest risk associated with ARMs is that you won’t be able to afford the monthly payments once the fixed period ends. However, if you expect your income to grow during the fixed rate period, or if you plan to relocate before the fixed rate period ends, then you may not be concerned about long-term affordability.

Other Mortgage Types

Some mortgages lenders offer interest-only mortgages, in which the first several years of payments cover interest only. This can lower your monthly payments because you aren’t repaying any principal in the first several years. Some folks view this kind of mortgage as the equivalent of rent, especially if they don’t plan to remain in the home once the interest-only period ends.

Negative amortization loans are a special kind of interest-only mortgages, in which you pay less each month than the amount indicated by the APR, for a set number of months. The lender adds the interest-payment shortfall to your loan principal, so that every month increases your indebtedness. These are extremely risky and hard to find nowadays. Lenders calculate DTIs ratios based on what you’ll owe at the end of the negative amortization period.

Balloon Mortgages

A balloon mortgage is a short-term fixed rate mortgage with the entire principal amount due when the term ends. You either have to pay off the loan balance with the single balloon payment after, say, five or seven years, or else refinance the loan. Balloon mortgages often have lower APRs and might make sense if you are an investor that is planning to flip the home in a short period of time.  Balloon loans are not available for residential, owner occupied borrowers.

What’s Best For You?

During period like now when interest rates are low, it makes sense to lock in a good rate with a fixed rate loan. An ARM might make sense if current interest rates are high, or if you plan to stay in your home for only a few years. Balloon, interest-only and negative amortization loans are risky and should be avoided unless you have compelling reasons. A 30-year term makes sense because it stretches out your payments and thus lowers your DTI. As mentioned, you might be able repay your 30-year mortgage faster by paying more than required each month, without locking you into a shorter term or raising your DTI ratio.