Choosing a Fixed Rate or Adjustable Rate Mortgage?

Buying a home involves hundreds of decisions, from picking a neighborhood to planning new paint colors. From the point of view of your financial health, no decision is more important than the mortgage you choose. If you are a first-time homebuyer, you might find the many mortgage-related options a little intimidating. Not to worry. We’ll review the most sensible choices, so you can make an informed decision about choosing a fixed rate or adjustable rate mortgage.

How a Mortgage Works

Your mortgage is a loan you take out to pay for the purchase of a home. The property you purchase serves as collateral for the lender. Depending on the loan program, your eligibility and the property circumstances, a down payment may range from zero to substantially more than 3.5 percent. The mortgage generally finances the remaining purchase price, subject to applicable program limits and closing costs. You then pay back the mortgage in monthly installments over the loan term, which is usually 15 or 30 years, although other terms are available. If you fail to make your payments, the lender can foreclose. This forces a sale of the home to return the money they lent you.

In a plain vanilla mortgage, your monthly payments are split between principal and interest. In the early years of a standard amortizing loan, more of each principal-and-interest payment goes to interest because the outstanding loan balance is higher. As the balance declines, more of each payment goes to principal. Mortgage-interest deductions may be available to taxpayers who itemize and meet applicable IRS requirements, but they are not available in every situation. In later years, the process known as amortization shifts the payment balance from interest to principal. By the last years, very little of your payment amount goes toward interest. Your equity in your home is its current market value. Specifically, it’s that value minus the amount you’d have to spend today to pay off the remainder of your mortgage. As we’ll soon see, some mortgages follow different amortization game plans that can have huge implications for your finances.

How Underwriting Affects Your Mortgage

Even though a mortgage is collateralized by property, lenders don’t make money by foreclosing on delinquent borrowers. They want to feel secure that you can afford your mortgage, especially after the 2008 mortgage meltdown. Lenders evaluate your loan application in a process called underwriting, in which they examine several factors, including:

• Debt to income (DTI) ratios: Front-end DTI compares your housing payment to your gross monthly income; back-end DTI compares all of your recurring monthly debt to it. On a manually underwritten FHA loan, HUD’s standard limits are 31% front-end and 43% back-end. They stretch to 33/45 on an Energy Efficient Home, and as far as 40/50 when you have documented compensating factors such as cash reserves or residual income. Automated approvals on conventional loans routinely reach a 50% back-end ratio. Strength elsewhere in your file genuinely moves these numbers, so treat them as a starting point rather than a wall.
• Your down payment: The more you put down, the less you’ll owe and the smaller your DTI ratio. Also, larger down payments may qualify you for a higher DTI ratio limit.
• You credit history: Lenders like when you’ve used credit in a responsible manner, as reflected in a clean payment history and a good credit score.
• Savings: A thrifty attitude certainly helps, as lenders like applicants who have been able to accumulate savings and have a conservative attitude toward using credit. If you have substantial cash reserves, you may qualify for a higher DTI ratio limit.
• Budget: It helps if your new monthly housing-related costs will be not much greater than your current ones.

The Fixed Rate Mortgage

A popular choice among homeowners is to secure a fixed rate mortgage. With a fixed-rate mortgage, the loan’s interest rate is set when you close and does not change over the loan term. The annual percentage rate (APR) is a separate disclosure that reflects the cost of credit, including certain finance charges. You know up front how much you’ll pay on the sum total of principal and interest each month. That’s because it’s always the same number. Your monthly payments may also include other costs, the primary one being escrow. Lenders frequently build an escrow account into your loan agreement to prepay your property taxes and possibly your mortgage and/or homeowner’s insurance. If your loan requires mortgage insurance, how long you pay it depends on the program. On a conventional loan the Homeowners Protection Act lets you request cancellation once the balance reaches 80% of the home’s original value, and requires the servicer to drop it automatically at 78%, provided you are current on payments. FHA works differently: on most loans with a case number dated on or after June 3, 2013, annual mortgage insurance runs 11 years if you put at least 10% down, and for the full mortgage term if you put down less. Homeowners insurance is separate, and is required for as long as you have the loan. Escrow might also include homeowner association fees and perhaps other items.

The standard, no-frills fixed rate mortgage has a 30-year term. While this spreads the payments over a long time period, it also generates more interest than would a shorter-term period of, say, 15 years. Your financial situation will usually dictate the loan term that makes the most sense. You can have the best of both worlds by taking a 30-year loan but doubling up on your payments, so that the actual term is only 15 years or less. This has the virtue of cutting down on the interest you’ll end up paying. Yet it also gives you wiggle room if your finances take a hit and you have to fall back to single monthly payments. Also, your DTI ratio may preclude you from a loan term shorter than 30 years.

Adjustable Rate Mortgages

Adjustable-rate mortgages (ARMs) feature an interest-rate that can change over time. The interest rate is fixed for a certain period, such as three, five or seven years, before it becomes adjustable. ARMs commonly provide interest-rate caps that limit how much the rate can change at an adjustment and over the life of the loan. After the initial fixed period, the rate is generally determined by the loan’s disclosed index and margin, subject to those caps, so it may increase, decrease or remain unchanged. Lenders sometimes attach low “teaser” rates to the ARM fixed rate period to induce folks to buy homes. ARM terms are expressed as the fixed period/the reset period such as 5/1 or 7/1. The reset period is the number of years (usually one) before the newest rate is applied to the mortgage in the adjustable period. For purposes of DTI calculation, lenders often add 2 percent to the initial interest rate to determine eligibility for 3/1 and 5/1 ARMs, but not for 7/1 loans.

The biggest risk associated with ARMs is that you won’t be able to afford the monthly payments once the fixed period ends. However, if you expect your income to grow during the fixed rate period, you may not be as concerned about long-term affordability. The same is true if you plan to relocate before the fixed rate period ends.

Other Mortgage Types

Some mortgages lenders offer interest-only mortgages, in which the first several years of payments cover interest only. This can lower your monthly payments because you aren’t repaying any principal in the first several years. Some folks view this kind of mortgage as the equivalent of rent. This is especially true if they don’t plan to remain in the home once the interest-only period ends.

Negative amortization loans can permit payments that are less than the interest accruing each month. The unpaid interest is added to the loan balance, causing the amount owed to increase. By contrast, an interest-only payment generally covers accrued interest but does not reduce principal. These are extremely risky and hard to find nowadays. Lenders calculate DTIs ratios based on what you’ll owe at the end of the negative amortization period.

Balloon Mortgages

A balloon mortgage is a short-term fixed rate mortgage with the entire principal amount due when the term ends. You either have to pay off the loan balance with the single balloon payment after, say, five or seven years, or else refinance the loan. Balloon mortgages often have lower APRs. They might make sense if you are an investor planning to flip the home in a short period of time.  Balloon-payment mortgages for owner-occupied homes are restricted and are available only in limited circumstances. Before considering one, confirm whether the product is permitted and appropriate for your situation.

What’s Best For You?

A fixed-rate loan can suit borrowers who value a stable principal-and-interest payment over a long holding period. An ARM can be worth considering when its initial terms, adjustment caps, and your expected time in the home make the potential payment risk acceptable. Balloon, interest-only and negative amortization loans are risky and should be avoided unless you have compelling reasons. A 30-year term makes sense because it stretches out your payments and thus lowers your DTI. As mentioned, you might be able repay your 30-year mortgage faster by paying more than required each month, without locking you into a shorter term or raising your DTI ratio.