Fixed vs. adjustable mortgage rates

Buyers should have a basic understanding of the different loan types available in the market before settling on a particular package.

The depression of interest rates in past few years has made the dream of home ownership a reality for most Americans. Many financing options are available for the taking. Finding the right package amid the sea of offerings can be overwhelming for the buyer. As with any major investment, having a basic understanding of the financial options can potentially save buyers future headaches and extra costs.

Mortgage packages come in two basic flavors, with variations in the middle of the spectrum between these two extremes. The basic financing options available to buyers are the fixed-rate mortgage and the adjustable-rate mortgage.

A fixed-rate mortgage has been the traditional financing option for most buyers. As the name implies, a fixed-rate mortgage maintains the same fixed interest rate for the life of the loan. A fixed-rate mortgage is secured using real property. Interest rates on this type of loan are based on long-term bond rates. For example, a loan of $200,000 at an interest rate of 10% for a 30-year term means that the interest rate of 10% is paid by the buyer until the loan is canceled or the buyer refinances. Generally with a fixed-rate mortgage, a buyer has the option to select a 15-year term or a 30-year term. A fixed-rate mortgage is the lowest risk financing option available to the buyer.

An adjustable-rate mortgage is a relatively new phenomenon for buyers. With adjustable-rage mortgages, the interest rates are set at a lower percentage initially, but can be adjusted periodically to account for interest rate fluctuations in the market over the life of the loan. The interest rates are usually set for the first six months of the loan, and vary periodically every six to twelve months, depending on the index from which the interest rates are derived. Normally, adjustable-rate mortgages are capped at a 2 percentage point raise per year, with a maximum variation of 5 to 6 percentage points rise over the life of a loan. These types of mortgages are based on the short-term interest rates of the index plus a margin. With adjustable-rate mortgages, only 30-year terms are available. Because of the possibility of market fluctuations, an adjustable-rate mortgage is a higher risk financing option.

With these two types of financing plans available, which should a buyer select? Individual risk tolerance plays a large role in dictating which option a buyer selects.

Fixed-rate mortgages are for the risk-averse buyer, where stability and adherence to a strict budget are necessary. Those who gravitate towards this type of financing believe that interest rates will rise over the course of the loan. A fixed-rate mortgage will secure this lower interest rate in the event of any rate increases.

On the other hand, if a buyer is a risk-seeker, then an adjustable-rate mortgage is the thing, since adjustable-rate mortgages gamble on future interest rates. The initial rates of the adjustable-rate mortgages are lower than that of the fixed-rate mortgages. The advantage of using such a loan is that the lower interest rate may qualify the buyer for a larger loan. A buyer goes into this financing option with the belief that the interest rates will remain steady or decline in the future. An individual should seek an adjustable-rate mortgage if their budget can handle the payment fluctuations. If you seek an adjustable-rate loan, you are anticipating that increases in income will keep steady with increases in payment.

Adjustable-rate loans, however, carry an added risk. If interest rates increase by 1 to 2% and remain at that level for the life of the loan, then the buyer ends up paying more for the property than if the property were financed using a fixed-rate loan. On the other hand, if interest rates continue to drop, an individual who is locked in to a constant interest rate will eventually pay more than one locked in with an adjustable-rate mortgage. With both types of packages, the buyer is free to refinance the loan after two years, although closing costs will be associated with each refinancing of the loan. Refinancing is attractive if the interest rates drop during the first years of repayment.

Today, many options that incorporate characteristics of each of the two basic types exist in the market and are heavily advertised in order to draw in new buyers and people seeking to refinance their homes. Before the buyer makes any decision about a mortgage package, the buyer should make an effort to understand the risks involved in each, and to assess their financial situations before resolving to settle on a single action. After all, if the buyer doesn't do his or her homework, the buyer will be the one to suffer the burdens of additional costs.

© High Speed Ventures 2011