Pros And Cons Of Fixed Rate Versus Adjustable Rate Mortgage

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Pros And Cons Of Fixed Rate Versus Adjustable Rate Mortgage

This BLOG On Pros And Cons Of Fixed Rate Versus Adjustable Rate Mortgage Was UPDATED On May 26th, 2018

With a first time home buyer or even a seasoned veteran home buyer, applying for a home loan can be a very stressful process. Home buyers will most likely have a lot of questions not just for their realtors but for their loan officers.

  • Most consumers may have went through a total of half a dozen mortgage application process in their lifetime, if that
  • Most do not remember the last time they went through the mortgage process
  • Even if it has been a few years ago, there has been many changes in lending guidelines
  • Majority of licensed loan originators only know a fraction of the rules and regulations in mortgage lending
  • Depending on buyers goal, there are differences that may or may not benefit in choosing fixed rate versus adjustable rate mortgage
  • With fixed rate versus adjustable rate mortgage, ARMs normally have lower rates than fixed rate mortgages

One of the major factors borrowers should consider is whether to get a fixed rate mortgage versus an adjustable rate mortgage , commonly referred as an ARM.

  • Sometimes an adjustable rate mortgage may be better for borrowers
  • Depends on goals on how long home buyers intend on living at new home purchase
  • Also depends on how low borrowers credit scores are
  • Borrowers with lower credit scores may want to refinance at a later date so an adjustable rate mortgage may be more of a benefit
  • Borrowers with higher debt to income ratios may benefit with going with a 7/1 ARM

 Adjustable Rate Mortgages

First time buyers who intend on buying a starter home and intend on moving after 5 to 10 years, an adjustable rate mortgage may be a better option for them.

  • For example, many first time home buyers may purchase a condominium unit or small town home as their first home
  • They may intend on buying a larger home once they get married
  • Married couples who intend in having children in the future and may want to upgrade to a larger single family home
  • In situations like these, an adjustable rate mortgage may be a better fit for them
  • Adjustable rate mortgages have lower interest rates during the fixed rate period
  • It then adjusts after the fixed rate period is over
  • Can change depending on the index the adjustable rate mortgage is based on
  • Adjustable rate mortgages are 30 year amortized term loans
  • The most common adjustable rate mortgage are:
    • 5/1 ARM where the mortgage rate is fixed for the first five years of the 30 year loan program and adjusts every year for the remaining 30 year period
  • The adjustment rate is the index plus the margin
  • The margin is a fixed rate and the index changes depending on the index such as the following:
    • CMT
    • Libor
    • COFI, or other index the lender bases the ARM 
  • There is caps on adjustable rate mortgages
  • In the event the index sky rockets, there is cap where the rate cannot exceed
  • Loan originator can explain how the fixed rate period, the adjustment rates, and the caps work

Fixed Rate Mortgages

With Fixed Rate Mortgages interest rates will remain the same for the 30 year term of the mortgage loan.

  • Fixed rate mortgage loans offers security and stability to homeowners
  • Homeowners are rest assured because mortgage principal and interest will never change during the 30 year term of their mortgage loan
  • Property taxes and homeowners insurance can change and increase over the period of time
  • However the principal and interest will remain the same for the term of the 30 year term of the mortgage loan

Using ARM To Lower DTI 

With adjustable rate mortgages, there is the qualifying rate and the note rate. ARMs generally have lower mortgage rates than fixed rate mortgages. With 5/1 ARMs, lenders use the qualifying rate. With 7/1 Adjustable Rate Mortgages, lenders will use the note rate. How qualifying mortgage rates works is lenders takes the note rate and adds a margin of normally 2% and the sum of the note rate plus the margin is the qualifying rate.

Lets use a case study:

  • 5/1 ARM Note Rate 4.0%
  • 7/1 ARM Note Rate 4.125%
  • 30 Year Fixed Rate Mortgage 5.0%
  • Margin For Qualifying Rate 2.0%
  • Borrowers that chooses a 5/1 ARM, mortgage underwriter will take the 4.0% note rate and add a 2% margin so the qualifying rate will be 6.0% when qualifying debt to income ratios
  • However, if borrower chooses the 7/1 ARM at 4.125%, with 7/1 ARMs, lenders will just use the note rate to calculate housing payment 
  • Therefore, it is best to choose 7/1 Adjustable Rate Mortgages when qualifying borrowers who exceed the maximum debt to income ratio caps

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