Fixed vs. ARM: Four Questions to Ask When Comparing Your Options

Here are four questions that can help you make a more informed decision when comparing an adjustable rate mortgage (ARM) vs. a fixed rate mortgage.

1 - How do ARMs work?

Most ARMs have an initial note rate that is fixed for a period of time... usually 3, 5 or 7 years.  See Figure 1 for details.

After the initial fixed period, your mortgage interest rate would change based on adding the then-current index, to the margin.  See Figure 2 for details.
It's important to pay attention to the "caps" on your loan because these caps indicate how much your mortgage rate can change after the initial fixed period.  See Figure 3 for details.

2 - What is my timeline for refinancing or selling the house?

The main reason why people consider ARMs is because they often have a lower interest rate than fixed-rate loans.  The risk is that the rate on your ARM could go up in the future, after the initial fixed period.  So if you think that you may sell the house or refinance within a 3-4 year timeline, you might want to consider a 5 year ARM to buy yourself a few extra years in case plans change.  Likewise, you may want to choose a 7 year ARM if your timeline is 5-6 years.  When considering your timeline, keep in mind that most people move or refinance within 7-8 years of buying a house.  Your timeline could be shorter or longer than that based on your objectives.
The bottom line is that paying the higher rate on a fixed rate mortgage is like paying for an insurance policy that you may not need... especially if you invest the extra monthly cash flow that you'll experience from the lower rate on an ARM.

3 - What will I do with the extra cash flow?

Here are three options if choosing an ARM will produce additional cash flow in your situation:
  • Option 1: Invest the extra cash flow. This could be worth considering if you're looking to build your retirement account or a child's college fund.
  • Option 2: Spend the extra cash flow. This could be worth considering if you're looking to enhance your lifestyle or create more life experiences.
  • Option 3: Use the extra cash flow to bid higher on a home or buy a more expensive house. This could be worth considering if you're facing tough competition from other buyers in your market and if home values are likely to increase.

4 - What is the risk involved with either option?

The main risk with an ARM is that your mortgage rate and monthly payment could go up after the initial fixed period. You could reduce the potential impact of that risk by choosing an initial fixed period that is a little longer than your timeline.  Also, make sure to understand the index used on your ARM so that you know what could cause your interest rate to go up or down in the future.
The main risk with a fixed rate loan is that you're losing cash flow NOW in exchange for the chance of saving money at some point down the road if you keep the loan for more than 3, 5 or 7 years.
In either case, this is probably one of the most important financial transactions of your life. My commitment is to communicate and strategize with you every step of the way.  Contact me for more info and I'll be happy to run the numbers for your specific situation!

Source: CMPS

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