If you buy this type of home, don’t get a variable rate mortgage
If you are buying a home, you should aim to get the most competitive interest rate possible on a mortgage, a rate that makes your monthly payments more affordable and helps you spend less on interest. And for that, you might be tempted by a variable rate home loan, or ARM. While it can be smart in some situations, if you are buying your home forever, you are probably better off with a fixed rate loan.
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How does an adjustable rate home loan work?
When you take out a fixed rate mortgage, you are guaranteed the same interest rate for the duration of your loan repayment. With an ARM, you lock in your initial interest rate for a limited period of time, and then that rate can adjust. With an ARM 5/1, for example, the rate you start with stays in place for five years. But after those five years, your rate adjusts once a year.
Here’s the cool thing about ARMs – your rate isn’t guaranteed climb. Your rate may adjust downward, depending on market conditions. But when you sign up for an ARM, you should assume that your rate will increase. And that’s why an ARM may not be your best bet if you’re buying a home to live in for a very long time.
A better choice for your home forever
If you are buying a home from the start, an ARM could be a good bet. Say you get an ARM 5/1 and lock in an interest rate of 2.9% for five years, while paying 3.2% interest on a 30-year fixed loan. If you move out of your home within five years, you get a financial advance because you sell (and therefore pay off that mortgage) before your rate can adjust upward.
But if you are buying a home forever, a fixed mortgage is a safer bet. You lock in your interest rate for many years and don’t have to worry about it going up over time. And if you’re able to trade off the highest monthly payment for a 15-year loan, you could get a lower interest rate than even an ARM can offer.
Here’s a look at mortgage rates at the time of writing:
As you can see, you get a better rate with a 15-year loan than with an ARM, and you get a comparable offer with a 20-year mortgage.
What about refinancing an ARM?
You may be considering using an ARM for a permanent home and refinancing that loan if your rate goes up. But what if refinancing rates become less competitive?
Suppose you can now lock in a 30-year fixed loan at 3.2%. What if, in five years, the average 30-year loan had an interest rate of 4.7%? You might regret having an ARM.
While an adjustable rate mortgage makes sense when you plan to move fairly quickly, it is risky when you plan for the long term. Carefully consider the pros and cons before taking out a loan where the interest rate could get worse.