Buying a home is one of the biggest decisions most people make in their lifetime. It is a huge investment and for many the idea of committing to a mortgage (one that could last up to 30 years to pay off) is a stressful experience. When buying a first home there are many factors to consider. What type of house do you want? How much can you afford? Will you be able to build equity in the current housing market? However, one of the biggest challenges for many new home buyers is understanding the various mortgage options and how the constantly fluctuating interest rates can affect them. Here’s how to understand the difference between fixed rate mortgages and adjustable rate mortgages.
Fixed Rate Mortgages
Fixed rate mortgages offer the buyer a consistent rate for the period assigned to the mortgage. For example, if you lock in at a 30 year mortgage your rate will not increase for the life of your loan. The benefit of this type of mortgage is that it makes it easier for the borrower to budget monthly expenses because payments remain the same every month. These types of mortgages are easy to understand for the new home buyer and are good for borrowers who are at the upper end of their budget and can’t afford any surprises. Fixed rate mortgages are also good for home buyers that plan to stay in their home for the duration of their mortgage. However, fixed rate mortgages don’t protect buyers if home values drop. In this scenario payments can become overvalued as equity falls behind.
Adjustable Rate (ARM) Mortgages
In comparison, monthly payments of adjustable rate mortgages go up and down each time the rate resets. Adjustable rate mortgages reflect short-term rates and are usually lower than the longer term mortgages. ARMs allow home buyers to purchase a larger more expensive home because interest rates are lower. The lower monthly payments are good for borrowers who want to take advantage of lower rates but have room in their budget if rates increase. However, many ARM loans begin with teaser rates that are below the indexed rate and in the long term may increase as rates reset to a market rate.
Let’s look at an example. Monthly payments on a $400,000 loan for a 30 year fixed rate mortgage at 4.31 percent would be $1981.84 compared to a 1 year adjustable rate mortgage at 3.00 percent, which would be $1686.00 resulting in a savings of approximately $300 per month.
Most first time home buyers rush into the housing market when rates are low without really understanding what they are getting into. Mortgage rates are important but borrowers have to consider the overall cost of home ownership including things such as the amortizaton period, payment options, and how the different types of mortgages can effect payments over time.
Often many people think that taking on a longer mortgage keeps repayments low. However, there is significantly less total interest repayable on a 15 year term than a 30 year mortgage.
Buying a first home can be exciting but it is also very scary. Especially for first time buyers who don’t have a clear understanding of interest rates and various mortgage products. Although there is a lot of stress that comes with purchasing a first home, it is a great investment and one that you will rarely regret as long as you ensure you know what you are getting into.