Whether you are purchasing a home or refinancing a home, you will be faced with several decisions. One of these decisions is whether to apply for a variable rate (or adjustable rate) mortgage or a fixed rate mortgage. Making this decision is never easy and often depends on a number of factors that may impact your eligibility for a loan. Before making a final decision, make sure that you understand the pros and cons of both types of loans and when one may be better for your financial future than the other.
Deciding on a variable or fixed rate mortgage
Some of the questions that you will want to discuss with your lender when considering a fixed rate mortgage or an adjustable rate mortgage include:
- Monthly payments – how much will your monthly payments be over the life of the loan? Lenders will be unable to accurately predict the monthly payment on an adjustable rate mortgage, but they can provide a “worst case” scenario.
- Interest rates – there are several different types of adjustable rate mortgages including blended rates. Talk to your lender about interest rate changes and find out about caps on changes. In some cases, mortgage lenders can offer you an adjustable rate loan that changes to a fixed rate loan later (called a hybrid mortgage).
- Loan terms – find out what the overall term of the loan is. Fixed rate loans are typically offered in 15, 20 or 30 year terms. Adjustable (or variable rate) loans may be fixed for specific periods of time such as one year, three years of five years and then become adjustable. Other products may be adjustable for specific periods of time then become fixed.
- Prepayment penalties – this is one of the most important questions to ask your mortgage lender if you are considering a variable rate loan. High prepayment penalties are common with these loans and can be high enough to prevent you from refinancing your loan into a fixed rate loan.
Rates matter but use caution
One of the biggest attractions to an adjustable or variable rate mortgage is the lower starting interest rates. However, while these rates may be initially appealing, they do not tell the entire story. Interest rates on variable loans change based on the mortgage contract. In some cases, they may change as often as every six months depending on the loan. When this occurs, borrowers can find themselves in real trouble with their monthly mortgage payments.
When an adjustable rate is sensible
There are times when accepting an adjustable rate mortgage makes a lot of sense. Some of these times include:
- When you do not plan to stay in the home – if you are not planning to stay in your home for more than five years, an adjustable rate mortgage may be ideal. Before accepting this however, make sure that you check with the lender about prepayment penalties.
- When you expect a financial change – borrowers who are anticipating a change in their financial circumstances may benefit from a variable rate loan. For example, for those who are expecting a promotion, which often means a larger income, an adjustable rate loan may be ideal. Again, it is important to understand what prepayment penalties may be involved.
- Expecting a windfall – borrowers who are pending a legal settlement or an annuity payoff may benefit significantly from a variable rate mortgage. These windfalls may allow them to pay off the entire loan at settlement.
Impact on insurance
When you take a loan out for a home, your lender will require you to have homeowners insurance. In addition, if you are borrowing more than 80 percent of the value of your home, you will also be required to have Personal Mortgage Insurance (PMI). Personal mortgage insurance allows the lender to recoup any losses they may incur if you default on your loan. Before you agree to a variable rate mortgage, check with your lender and ask what impact it may have on PMI if you accept a variable rate mortgage.
While there may not be an impact on your mortgage initially, if your home loses value and you have an adjustable rate mortgage, you may wind up owing more money than your home is worth at any given time. In these cases, the lender may have the right to require you to obtain PMI when your rate goes up.
Always question your lender
When you are considering a home mortgage, you are making a long-term commitment to paying a substantial amount of your income out each month. In addition to your mortgage payment, you will also have to pay property taxes, water bills and home insurance costs.
Fixed rate mortgage loans offer numerous benefits including:
- You will always know how much your payment will be
- Your loan term is fixed at the time of signing
- You can usually refinance without a prepayment penalty
Adjustable rate mortgages offer some benefits as well. However, there are very specific cases when they may be a bad idea for some borrowers including:
- When your job tenure may be threatened by layoffs
- If you are anticipating any reduction in income (illness, retirement, etc.)
- If the loan terms include a substantial prepayment penalty
When making a decision as to whether to use a variable rate loan or a fixed rate loan, it is crucial that you discuss your entire financial situation with your loan officer. At Core Mortgage Financial we will help you evaluate each loan and make sure that you understand the benefits and drawbacks to each type of loan before you decide which one is right for your individual needs.
- Non-Qualified Mortgage: Who is responsible – Sometimes lenders put unqualified borrowers into bank statements only type of adjustable rate mortgages.
- How to determine if you qualify for refinancing your home – Since interest rates are currently low, you might be considering refinancing your home.
- Understanding the 5/1 Jumbo ARM – Those who are long time mortgage brokers report clients being confused by various mortgage terms.
This blog is for informational purposes only. The blog content is our opinion, please contact our office with any questions. Rates, Programs, Guidelines are subject to change without notice. We are not affiliated with any government agencies.