When it comes to choosing a mortgage it pays to be informed about your options and which type of mortgage works best for you and your finances. Recently the Federal Reserve called for a change in the way mortgage lenders must clarify their products, as a study showed that a high proportion of borrowers had no knowledge than a rise in interest rates could affect their monthly payments.
Whichever type of mortgage loan you choose you will have the option of a fixed rate or an adjustable rate mortgage (ARM), known as a variable mortgage in the UK. U.S fixed rate mortgages are generally long term whilst in the U.K. they are short term and borrowers automate onto the variable rate when their fixed rate ends.
Adjustable rate mortgages follow interest rate changes, thus if interest rates go up so does the monthly mortgage payment. On the plus side they can also go down. In contrast a fixed rate mortgage remains at the same interest rate for the term of years it is fixed at. ARM rates can be lower than fixed rates to begin with, but if interest rates rise then the interest rate may exceed that of the fixed rate which it was originally compared to.
American adjustable rate mortgages have a built in cap, which states both an annual and life time interest rate which cannot be exceeded. It is important for anyone considering an ARM to be aware of the capped figures and consider the worst case scenario which a rise in interest rates could lead to. It could be the case that interest rate rises make the monthly mortgage payment unaffordable. Borrowers should never assume that interest rates won’t rise and ARM’s epitomise unpredictability.
Borrowers who have a financial cushion to cope with possible interest rate rises are better placed to take the risk of ARM’s than those who are on a tight budget and prefer to be cautious. Someone who follows the markets could take a gamble that interest rates will fall and they will thus save money as their mortgage reduces.
Those who opt for fixed rate mortgages could well see interest rates fall and end up paying more than they need and thus consider refinancing to a lower rate. The costs of refinancing are high and can be avoided by those on ARM’s unless they choose to move from an ARM to a fixed rate mortgage. Those who are not planning to remain in their home for more than a few years may well find an ARM more suited to their needs and will avoid any penalties which may arise from extricating themselves from a fixed rate.
The inevitable pro of an adjustable rate mortgage are the possibility that interest rates will fall thus reducing their monthly mortgage payment. They will appeal more to those who don’t want to be tied into a fixed rate which may prove to be an expensive choice. They have the advantage of a built in cap which borrowers can apprise themselves of in advance and determine the risk.
The biggest risk which adjustable rate mortgages pose is the chance that interest rates may be raised so much that their mortgage simply becomes unaffordable. This is more likely to affect those who failed to comprehend the nature of the caps outlined in the mortgage terms. Those who prefer certainty and the security of knowing exactly what their home will cost on a monthly basis may feel that an ARM is just too much of a financial gamble. In the long term fixed rate mortgages have shown to be the least expensive option overall.