The main reason people opt to refinance their present loan is to lessen the burden of paying them. But for some, choosing which refinancing scheme is a burden in itself. Which one is better? Which is better suited for your present situation? Is a fixed-rate mortgage better for you or an adjustable-rate mortgage? If you are having a hard time choosing which one will work best for you, here are some comparison on the pros and cons of both.
FIXED-RATE MORTGAGE OR FRM:
Fixed-rate mortgages are mortgage loans that have a fixed interest rate throughout the duration of the loan. All the payments remain unchanged. This is the more popular refinancing scheme since people tend to want more security in the future.
Pros of fixed-rate mortgage
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The amount to be paid is fixed. It will not be affected by unforeseen future events that will cause the loan interest rate to rise like inflation or economic recession.
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Interest rate risk is the sole responsibility of the lender. Since the rate remains unchanged, then the risk of increasing interest in the future will be the sole burden of the lender and will not be passed on to the borrower.
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Easier to budget. You can plan for the future better since you know exactly how much you need to save for. This option offers more certainty.
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Simpler choice to make. This mortgage is simpler to understand. You know from day one how everything is computed and how much of your money will be spent on it.
Cons of fixed-rate mortgage:
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Fixed-rate mortgages are more expensive. This kind of loan usually is more expensive than adjustable-rate mortgage and has a higher interest rate.
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Unaffected with drop in interest rates. As fixed-rate mortgages are unaffected by an increase of interest rate, they remain unchanged too when interest rates decrease. It is a risk that you have to take if you choose this option.
ADJUSTABLE-RATE MORTGAGE:
Adjustable-rate mortgage or ARM is the type of mortgage loan whose interest rate can change over the duration of the loan. The interest rate is usually constant for a fixed timeframe then changes sporadically after that.
Pros of adjustable-rate mortgage
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Lower initial interest rate. Initial interest rate of ARM is usually lower than fixed-rate mortgages and is locked on this rate for a period of time.
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Can take advantage of falling interest rates. Their monthly payments will be lesser as interest rates get lower. There is no need to refinance just to take advantage of a sudden slump in interest rates.
Cons of adjustable-rate mortgage:
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Interest rates may increase. The borrower assumes the risk of increasing interest rates. Your monthly payments can get higher.
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More complex. ARM is more difficult to understand and harder to compute. There are a lot to take into consideration like loan caps, initial interest rate and margin.
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Offers lesser security. As opposed to FRM, ARM offers no security. It is more difficult to plan for the future with a changing amortization.
So which one is best for you?
The best time to choose FRM is when the interest rates are at its all-time low, when there is no forecast that interest rate is still going to drop. It is also advisable to choose this option when you are certain that interest rates are about to increase in the coming years.
On the other hand, if you plan to sell your property in the near future for whatever reason, relocation or maybe retirement, ARM is better for you with its lower initial interest rate. In a nutshell, if you want security, FRM is your best choice but if you are willing to take the risk of uncertainty and if large amortization is just too expensive for you at this time, then go with ARM.
If you had to choose today between a FRM or an ARM which one would you choose and why?
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{ 4 comments… read them below or add one }
My mortgage balance is small enough that I could pay it off in 5 years. I would select 5 year ARM. I would enjoy the lowest possible rate and have it paid off before it could increase.
Krants,
That’s a great idea. I would probably do the same if I only had 5 years left as well.
As low as fixed rates are right now, I really don’t see the benefit from doing an ARM. You might save a small percentage on the initial rate, but I believe we have hit the bottom and rates are only going to rise. A fixed rate helps me sleep better at night!
That is one good reason for having a fixed rate loan, you know what you’re getting into. Sometimes the interest rate risk isn’t worth the risk of the ARM.