Adjustable-Rate Mortgages vs. Fixed-Rate Mortgages

By: Yon Olsen
Submitted: 2007-01-17 16:16:14
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Many people have a hard time choosing between an adjustable-rate mortgage and a fixed-rate mortgage. It’s not hard to understand why someone would be concerned. Do you opt for the lower up-front rate and hope for the best in years to come or do you go for the always-safe fixed rate that never changes? The answer to the question actually depends on your specific needs and circumstances.

Let’s say you’re purchasing a home that you only plan to stay in for one or two years. An adjustable-rate mortgage offering a lower initial interest rate than available fixed-rate mortgages would make more sense. However, if you plan on staying in the home for the rest of your life, an adjustable-rate mortgage can be quite a gamble. As people who took out adjustable-rate mortgages during the lending industry’s record lows a few years back can tell you, interest rates can skyrocket at the drop of a hat.

The best way to figure out whether you should choose an adjustable-rate mortgage or go with a fixed-rate mortgage is to estimate what will happen to the loan’s interest rate and payments in specific scenarios. By calculating worst-case scenarios, you can see if you would be at risk of losing your home should interest rates spiral out of control. Calculating “what-if” scenarios can also help you determine if a fixed-rate mortgage would actually give you a lower monthly payment than your adjustable-rate mortgage if interest rates take even a slight hike.

Let’s say you were buying a long-term home for $250,000 and you were thinking about taking out a 3/1 ARM with an interest rate of 5 percent but that rate would only hold for three years. After that three-year period, the rate would fluctuate according to the Treasury index plus a margin of 2.5 percent. On the other hand you could take out a fixed-rate mortgage with a 6.5 percent interest rate. What should you do?

You can take the adjustable-rate mortgage, but if your interest rate goes up just one percent a year, five years after you buy your home you’d be paying more for the adjustable-rate mortgage than you would have paid had you taken out the fixed-rate mortgage.

In the above scenario, a $200,000 30-year ARM with an interest rate of 5 percent would cost you approximately $1,075 a month. If that interest rate increases by just 1 percent during the first adjustment period, your monthly payment will jump to approximately $1,190. If the same thing happens at your next adjustment, your payment amount goes up to more than $1,300. One more time and your payment is already at about $1,430 a month. To make matters worse, the amount of your payment applied to principal is going down and the amount applied to interest is going up. If you would have opted for the fixed-rate mortgage with a 6.5-percent interest rate, your payments would have stayed at a steady $1,264 a month. Not a pretty situation.

While an adjustable-rate mortgage may be a better choice for short-term home purchases, people who plan on living in their home for many years to come may want to avoid the “what if” scenario and opt for a fixed-rate mortgage.

Article by Yon Olson, President of Accelerated Capital, Inc. – A Bend Oregon loan and mortgage company specializing in home and commercial real estate loans for all credit types. Call Yon at 541.617.0876 or visit us online for your Bend Oregon home loan or mortgage http://www.acc-cap.com/

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