This calculator helps you compare a fixed rate mortgage with both fully-amortizing and interest-only adjustable rate mortgages (ARMs).
With mortgage rates near their historic lows, fixed rate home mortgages are likely going to be a much better deal if you plan on living in the house for an extended period of time, as when rates reset on ARM loans the prior short-term savings will likely be more than offset by the higher rates for the duration of the loan, which can cause the interest-only loan payment to exceed the amoritizing 30 year fixed rate payments if mortgage rates spike high enough. For your conveniene, Freddie Mac's PMMS rates have been included to the right.
Adjustable Rate vs Fixed Rate Mortgages
A home mortgage is a loan from a lending institution that follows a written agreement between the buyer and the lender. Terms of the loan vary depending on the buyer's ability to match the current financial instrument with the predicted future situation in the household. In the past, a home shopper had confidence that the household income would stay relatively constant since jobs were sound and the economy was strong. Today, homebuyers struggle to accept long-term debt that could cause significant hardship if the local, or national, economy weakens even more. Sufficient information about the adjustable rate mortgage in comparison to the fixed rate mortgage should allow the home shopper to make an informed decision.
Benchmarks That Influence Mortgage Rates
Contrary to popular belief, financial institutions do not set mortgage rates based on random factors, economic events or weather forecasts. Banks are businesses with financial objectives that must be met to stay compliant with investor objectives and legal solvency requirements. State and federal government agencies enforce regulations to ensure that the bank has sufficient funds to back the depositors.
Mortgage rates are determined using a number of factors that will yield a return that makes the investment worthwhile for the institution. Losing money on mortgages is not a wise business practice.
Freddie Mac, or the Federal Home Loan Mortgage Corporation is a public, government-sponsored enterprise that publishes a set of required net yield rates for fixed and adjustable rate mortgages.
- The 10-year U.S. Treasury note yield is an important benchmark for bank loan rates. Government obligations have been considered the safest investments available. Lenders offer a loan interest rate that is 1.5 to 2.0 percent above the 10-year note yield.
- Rate decisions from the Federal Reserve determine the rates lenders will pay to borrow funds from this quasi-private central bank of the United States. Discount rates offered depend on the bank and the season.
- Adjustable rate mortgages can be indexed to the Prime Rate, which is offered to the banks' best customers.
Economic indicators work together to reveal the strength of the economy to these powerful entities. The value of the U.S. dollar on the global currency exchanges is important since the banks are global entities. Consumers are wise to recognize the ever-changing conditions in the financial markets that cause the lenders to change rates often. Mortgage decisions are affected directly by the frequency of rate adjustments.
Available ARM Mortgage Terms
Mortgage loans with an interest rate that changes at regular intervals are called adjustable rate mortgages, or ARMs. A loan of this type has a set interest rate for the first three, five or seven years. Lower rates allow the borrower to qualify for a larger loan since the approval process is based on the monthly payment.
Common ARM Loan Terms
Borrowers can choose from ARM loans that have a fixed interest rate for the initial period of the loan, which can be 1, 3, 5, 7, or 10 years. After the initial period, the interest rate will adjust annually for the rest of the loan term. Adjustments to the interest rate will be tied to the market indicators at the time of the adjustment. Borrowers must be aware of the economic conditions that can cause an ARM to become unaffordable overnight. Loan terms vary widely between banks. Some lenders have limits on the amount that a loan interest rate can adjust in a single year. This option prevents dramatic jumps in the interest rate on the ARM. In the loan documentation, the borrower will see the ARM term written as 5/1, which means that the interest rate remains constant for five years and then adjusts every year thereafter.
Popular ARM Terms
Borrowers are wise to evaluate life events prior to selecting the length of time for the initial loan period. The most common ARM loan is the 5/1 term, which offers five years at the same interest rate. Short-term stays in a house can dictate the length of time in which the borrower will want to lock in the interest rate. Job assignments, such as military locations, can guide the decision.
Fixed Rate Mortgage Terms
The potential homeowner should consider the length of time that the family anticipates living in the home. At times, the fixed-rate 30-year mortgage is the best choice since the original plan includes paying off the entire balance. Fixed rate mortgages can be paid off more quickly without penalty in many situations.
30-year fixed rate mortgage
Lenders set the 30-year mortgage interest rate where the borrower pays for the length in which the money is tied up in the loan. Over the life of the loan, the borrower will pay more for this loan than for one of a shorter duration. Long-term planning strategies include additional payments each year to reduce the amount of interest paid over the 30 years. The 30-year fixed-rate mortgage is the most popular mortgage offered.
20-year fixed rate mortgage
The 20-year fixed rate mortgage will have a lower interest rate than the 30-year since the bank will be able to use the funds 10 years sooner. Homeowners will seek this type of loan when the home price is lower and more funds are available for the down payment. The monthly payment will be higher for the same loan amount since the term is shorter.
15-year fixed rate mortgage
Some borrowers prefer a 15-year mortgage to reduce the amount of interest paid over the life of the loan. Lenders set the interest lower on these mortgages since the money is not tied up for as long. The monthly payment is higher for the same amount of money since there are fewer payments.
Differences Between ARM and Fixed-Rate Mortgages
Lenders set interest rates on ARM and fixed-rate mortgages based on the amount of money that must be earned during the loan term to make the investment profitable. Projecting the value of a dollar over the next 30 years causes the lender to take a conservative estimate that is a little higher than actual costs to ensure that the loan does not lose money. Interest rates on the adjustable rate mortgages are easier to project since economic indicators move in cycles, such as 3, 5, or 7 years.
Adjustable Rate Mortgages
- Lower rates and monthly payments during the initial lending phase. Lower payments allow the borrower to qualify for larger loans.
- Falling rates can be leveraged without refinancing the loan. ARM loans follow the markets, so the borrower has an advantage when the loan rates fall multiple times after the initial loan period.
- Borrowers have more cash available for other obligations each month.
- Frequent moves will be less expensive for the homeowner who needs to switch locations and loans more often.
- Significant increases in the interest rate and monthly payments can occur without warning throughout the loan term. Sharp increases in the ARM interest rate can create unaffordable monthly payments for the borrower.
- The first interest rate adjustment after the initial loan period is not limited by the annual limits on the loan. Adjustments to the payment can be extremely expensive for the unsuspecting borrower.
- Economic conditions can set an upward trend for home mortgage rates that make the ARM loan unaffordable over time.
- ARM loans are difficult to decipher for the borrower. Lenders can create a complex loan agreement that is expensive for the borrower and lucrative for the lender.
- Low monthly payments can cause the borrower to end up owing more on the loan at the end of the term than when the initial loan was established. Interest is applied to the loan balance over the lifetime of the loan even if the mortgage payment does not cover the interest expense.
Fixed Rate Mortgages
Interest rates and monthly payments will never change from the initial closing on the loan to the final payment. Inflation and market fluctuations have no impact on the loan terms.
- Homeowners are able to live according to a household budget that is predictable and affordable. Housing costs are manageable since the mortgage payment remains constant.
- Lenders are unable to apply any additional fees or adjustments to the fixed-rate loan.
Declining interest rates require mortgage refinance loans to reduce the interest rate on the mortgage agreement.
- A fixed rate mortgage written during a time of high interest rates can be too expensive for the borrower to qualify.
- Fixed rate mortgages are almost identical from lender to lender. Borrowers will find that a fixed-rate mortgage is sold multiple times to other lenders. The terms will never change, but the entity that receives the payment will change.
Rate Shift Risks in ARMs
Borrowers choose an adjustable rate mortgage loan for any number of reasons. A glimpse at the lender's perspective on this loan type is essential during the decision process. Interest rate shifts no longer rest on the lender when the mortgage has an adjustable interest rate feature. The borrower accepts all of the risk for the interest rate changes that happen following the initial loan term. Market forces can dictate higher interest rates that will be passed directly to the borrower. Interest rate jumps will cause the monthly payments to increase to offset the costs the lender would have absorbed on a fixed-rate mortgage.
Lower monthly payments during the initial loan term are the borrower's reward for shouldering the interest rate risk. The lender will accept an initial loss that can be recovered in the future years of the ARM agreement. Borrowers must beware of the potential for unaffordable loan payments once the initial loan term ends.
Borrowers Win With Longer Mortgage Terms
Homebuyers must consider many factors when selecting the best mortgage type and length for the current home purchase. Life events can change the household income level and monthly expenses. Upcoming events, such as college, business growth or retirement, can be anticipated. Serious illness can be a life-changing surprise that alters the family's ability to afford the rising costs of an ARM loan.
Personal situations will determine which loan type is advantageous:
Adjustable-rate mortgages are appropriate when the homeowner anticipates a move within the initial mortgage period. Lower interest rates and monthly payments reduce the household expenses while the family resides in the house. High market interest rates can be offset through the use of an ARM loan. Risks arise when the situation changes and the mortgage is held past the initial period. Borrowers must be prepared for that first payment jump if the market interest rates are rising. In some instances, the real estate market will not support a rapid sale of the property. Homeowners can be left with an expensive payment if life events shift in the wrong direction.
- Fixed-rate mortgages offer stability for the homeowner who plans to remain in the same house for the foreseeable future. Low interest rates can be set for the entire time the family lives in the house. Life events are easier to handle when the mortgage payment is constant. High interest rates can be refinanced when the markets shift.
Personal Finances Must Be In Order
Home ownership has always been the core of the American Dream. In reality, the cost of owning a home is much more than the monthly mortgage payment. The wise borrower will spend approximately five years preparing for a lifetime of owning homes of progressively higher value. Initial preparation can create a firm foundation on which the financial future can rest.
Repay all short-term debts – Credit card debt is a constant drain on the monthly budget. Repayment of all outstanding credit card balances will improve the household cash flow in preparation for home ownership. Switch to paying for all purchases with cash, since financial experts say that using cash causes people to spend 30 percent less during the year.
- Create an emergency fund – Every family should have a savings account with 6 to 12 months of income set aside. Building this fund is excellent preparation for saving for the house down payment. The money in this account is used to pay for household repairs that would cause the family to incur debt. Available funds are meant to sustain the family through a serious illness or the loss of a job.
- Trim the household budget – All unnecessary monthly expenses should be removed from the monthly budget. Extras are unnecessary when the family has a goal of owning a home. Each family will decide what is necessary, and how to reduce the amount of money spent each month. Entertainment costs are a significant category that can be trimmed to include more family time and free options for having fun. Eating out should be limited since buying groceries and cooking at home is much less expensive.
- Repair both credit reports – Each year, consumers should request a copy of the personal credit report from each of the three credit bureaus. All negative entries should be evaluated for accuracy. Mistakes must be corrected by following the written procedure on the credit bureau's website. This process can require months, so get started immediately. All negative marks that are legitimate must be handled through payments for outstanding debts.
- Save for the down payment – Anyone with the dream of living in the same house for many years will want to save enough money to make a 20 percent down payment at closing time. A conventional loan is less expensive for the borrower. Better interest rates are available to borrowers who are able to invest this significant amount of money.
- Choose the right mortgage – Borrowers must consider all of the information written above when deciding which loan is best. Short-sightedness can be expensive for the homeowner who opts for a loan that looks good on paper but does not meet long-term objectives. Every aspect of the loan must be considered in light of the economic conditions that will cause interest rates to rise in coming years.
Financial position is more important than ever for the homebuyer. Lenders have strict lending guidelines that are designed to mitigate the risk of nonpayment from all borrowers. Federal regulations have been tightened since the financial crisis of 2008. Borrowers must have pristine credit and stable income sources that will prevent problems with on-time payments for the foreseeable future.
General Guidelines for Affordable Houses
Lenders have determined that most borrowers can afford to invest a standard percentage of the household income in a mortgage payment. Borrowers must perform calculations that apply to the family's actual lifestyle. These guidelines can be too expensive for certain situations where the family participates in other activities that require monthly fees. Some households prefer to save more money each month for other long-term goals and pay a lower mortgage payment each month.
Lenders believe an affordable mortgage payment will meet two conditions:
The monthly mortgage and property tax obligation will be less than 31 percent of the gross monthly household income.
- The total monthly debt payments for the household will be less than 43 percent of the household income. All outstanding debts on the credit history are included in this calculation along with the mortgage payment and property tax.
Before agreeing to mortgage terms, the wise lender will be aware of the family's goals that will require funds as the children grow. Other priorities can influence how much money is available for the mortgage payment. Lenders can approve a loan that is too expensive for the family's future goals, which might include shifting to a one-income family when the first child is born.
The Need for a Crystal Ball
Mortgage selection can seem like a daunting task since the primary wage earner is responsible for paying the mortgage every month for years. Discussions with trusted financial advisors allow the home buyer to evaluate various scenarios. Financial goals must be factored into the decision to prevent unnecessary financial hardship. Management of the household income is more important than ever when the mortgage payment consumes nearly 40 percent of the monthly household income. Wisdom will guide the decision when sufficient information is available through multiple trusted sources.
Key Tips & Advice
Things to consider when buying a home:
- While the 30-year mortgage is the most popular term in the United States, a 15-year term builds equity much quicker;
- Home buyers in the US move on average of once every 5 to 7 years;
- Early mortgage payments apply primarily to interest rather than the principal;
- Using a shorter loan term, paying extra & making bi-weekly payments can better help offset any transaction-based expenses.
Do Home Prices Always Go Up?
In the United States real estate prices have went up about 6-fold since 1970.
Our monetary policy is biased toward inflation. If you back out general inflation, outside of during market bubbles, real estate typically performs roughly inline with general inflation. Rather than looking at raw prices, better metrics to use for analyzing real estate prices are:
- Home price vs median income.
- Purchase price vs rent.