Best Choice for You—ARM or Fixed-Rate Mortgage

When mortgage rates are low, a fixed rate mortgage is the best bet for most buyers. Over the next five, ten or thirty years, interest rates are more apt to go up than further down. Even if rates could go a little lower in the short run, an Adjustable Rate Mortgage’s teaser rate will adjust up soon and you won't gain much if you plan to stay in the house more than a few years (the broker can tell you your break-even point). In the long run, ARMs are likely to go up, meaning most buyers will be best off to lock in a favorable fixed rate now and not take the risk of much higher rates later.

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

Advantages of Fixed-Rate Loan:

• Rates and payments remain constant. There won't be any surprises even if inflation surges out of control and mortgage rates head to 20%.
• Stability makes budgeting easier. People can manage their money with more certainty because their housing outlays don't change.
• Simple to understand.

Disadvantages of Fixed-Rate Loan:

• To take advantage of falling rates, fixed-rate mortgage 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 fixed-rate mortgages into the secondary market. As a result, ARMs can be customized for individual borrowers, while most fixed-rate mortgages can't.

Advantages of Adjustable Rate Mortgages:

• Feature lower rates and payments early on in the loan term. Because lenders can use the lower payment when qualifying borrowers, people can buy 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 the rates—and their monthly payments—fall.
• Help borrowers save and invest more money. Someone who has a payment that's $100 less with an ARM can save that money and earn more of 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.

Disadvantages of Adjustable Rate Mortgages:

• Rates and payments can rise significantly over the life of the loan. A 6% ARM can end up at 11% in just three years if rates rise sharply.
• The first adjustment can be quite large because some annual caps don't apply to the initial change. Someone with an annual cap of 2% and a lifetime cap of 6% could theoretically see the rate shoot from 6% to 12% 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.