Fixed Rate or ARM?

You’re ready to purchase a home and now you're shopping around for mortgages to finance your purchase. There are two basic styles of mortgages available – fixed-rate and adjustable-rate mortgages. Their names are relatively self-explanatory. Fixed rate mortgages are loans in which the interest rate remains the same throughout the term of the loan. With adjustable-rate mortgages (commonly called ARMs), the interest rate can change depending on market conditions and the loan's indexed interest rate.

So, which mortgage should you choose? Well, it really depends upon what you know about the market and what you want to accomplish with your loan and home purchase. If you're the kind of person who likes to know exactly what you're going to pay this month, next month, and every other month over the term of your loan, you should stick with a fixed-rate loan. Once you sign the contract for this type of loan, your monthly payments will not change. The downside is that fixed-rate loans often start at a higher interest rate than you may be able to find from adjustable-rate mortgages.

Conversely, an adjustable-rate mortgage plan may be best for those who know (or at least have a pretty good idea) what the market is doing now and can be expected to do in the near future, or will only need the loan for relatively short period of time. ARMs lock in your interest rate for a temporary term that could range anywhere from one month to 10 years. When that initial term expires the loan's interest rate will adjust, and if the market has changed toward higher rates, your interest rate – and, consequently, your monthly payments, as well – will rise accordingly. On loans as large as that of a typical mortgage, the difference can be quite dramatic.

What are the benefits of adjustable-rate mortgages? For people who aren't planning to hold the loan for the full term, they can be a smart financial move. Since initial ARM rates are often lower than those of fixed-rate mortgages, you could come out ahead if you're planning to sell the property before the initial lock-in period ends. Investors who purchase homes they want to fix up and sell for a profit have often employed this tactic, expecting that they'll move the property in time and have paid less in interest than they would have with a traditional fixed-rate mortgage. Those who intend to keep their homes long tem may be wise to seek refinancing in order to guarantee an affordable fixed rate.

Problems may arise, however, if there's a delay in the sale. For those who are building another home and find themselves in a construction delay, or are trying to sell a property that they've revamped in a down market, the sale may not be as quickly forthcoming as they had initially planned. Once the initial lock-in period ends, the new interest rate may spike significantly, leaving the owner with potentially unaffordable payments. (Homeowners who intend to keep their properties for the long term may be wise to seek refinancing in order to guarantee an affordable fixed rate. The current housing downturn can be attributed in no small measure to many owners being blindsided with much higher mortgage payments after their ARM rates adjusted.)

For those with a solid game plan, adjustable-rate mortgages can still be a good way to shave a sizable amount off the interest dollars paid on a loan. In the current credit-strapped market, however, they've become more difficult to obtain. Just remember that the opportunity to save money through the use of an ARM also comes with a risk that things may not proceed exactly the way that you've hoped.