What is Fixed rate Mortgages vs. Adjustable Rate Mortgages?

Fixed rate Mortgages

The fixed rate mortgage (FRM) also known as “vanilla wafer” is the easiest of all mortgages, due to the interest rate is set at closing and it does not change through the term of the loan. Commonly, fixed-rate mortgages have a duration of 15-30 years, and account for 75% of all home loans. The Fixed Rate Mortgage has an alternative, called the adjustable rate mortgage (ARM) with an interest rate that changes according to the current conditions of the market. Sometimes people choose the adjustable rate mortgage because it offers a lower interest rate. But, this type of mortgage can be a bit risky as the rate is constantly changing which means your Fixed rate Mortgages  is uncertain and more difficult to provide for in the budget.

The Fixed Rate Mortgage is a good choice when the interest rates are low. If you have a stable income and you plan to have a home for 10 years or more, then this mortgage is the best deal. For a family that bought their dream house and is paying the 30-year fixed-rate mortgage while raising 2 or more children and a dog, it is most likely to enjoy a happy retirement after selling the home and move to Florida.

Fixed rate mortgage have been historically low during the past several years. People have been maintaining rates between 4 and 5 %, and paying that rate as long as they keep their mortgage. Let’s have a look at the past situation. In the 1980s, people in the USA were suffering because of double-digit interest rates that remained for almost a decade. Rates on a 30-year fixed-rate mortgage reached 10.13% in 1990 and 16.63 % in 1981, Freddie Mac’s Primary Mortgage Market Survey showed. Interest rates even got above 18 at some time. This is why people living during that period encourage their family and friends to get fixed-rate mortgage, or refinance into one, when the rates are single-digit.

Fixed vs. Adjustable Rate

In the case of an adjustable rate loan, the interest rate is linked to a certain economic indicator such as treasury bills, the Constant Maturity Index (CMI), the prime rate, the London Inetrbank Offered Rate (LIBOR). The terms of each loan can vary significantly and usually are marked by very low introductory rates for an exactly determined duration of 3, 5, or 10 years. These mortgages can be a great finding for young couples who want their income to grow faster, but at the moment don’t have a high enough revenue to be able to pay a high monthly mortgage. With an adjustable rate mortgage they will start with low promotional rates and their income will rise by the time their rate rises; thus the increased monthly payment will not be a problem anymore. Sadly, an adjustable rate mortgage can be a real catastrophe when the rates grow but the family income falls.

The greatest problem with ARMs is that they are unpredictable, thus it is difficult to develop a long-term financial plan. Meanwhile, fixed-rate loans are stable.

Advantages of fixed rate mortgage:

There are the following advantages of fixed-rate loans:

1. It is much easier to understand the Fixed Rate Mortgage than the ARM. Moreover, there you don’t have to worry about the frequency with which your interest rate changes, the rate cap, the financial index on which it is based, the way the payments are structured, how the rate is estimated, and if it can into negative amortization.
2. Security for buyers is provided as well as they are suitable for first-time homeowners.
3. They are appropriate for people who are interested in their monthly expenses as well as for those who want to maintain their home for a long time.
4. They protect from inflation. Due to inflation you pay more without getting more goods and the value of your dollar is being reduced. As a matter of fact the interest rate stays unchanged with a FRM, thus you will be paying less for your mortgage.
5. During the time when the interest rates are low, you can have an interesting financial deal by prepaying your FRM principal. For example: if your mortgage rate is of 6%, each time you prepay the principal, it will be equivalent to receiving 6% return on your money. In an environment where the interest rates are low you may get 1 or 2 % in a saving account or CD. During such periods it is advantageous to make a prepayment.

Disadvantages of Fixed Rate Mortgage

Fixed-rate mortgages are not that perfect. There are some disadvantages in comparison to other loans.

1. When considered in short term FRMs charge higher interest rate than ARMs. Nevertheless, if the rates of interest grow over the years, the Fixed Rate Mortgage rate can be much lower than that of the ARM.
2. Usually Fixed Rate Mortgage have higher initial monthly payments if compared to those of the adjustable-rate loan.
3. Fixed Rate Mortgage offer less flexibility than ARMs.
4. As the rates of interest on FR loans tend to be higher which results in higher monthly payment, you may not put in a claim for a mortgage that could be as large as in the case of a loan that offers a lower monthly payment.
5. How to choose the right Fixed Rate Mortgage?
   How would you choose which mortgage type is appropriate for you?
   Because it is impossible to see into the future, it is very important to know where you are going in life. If your intentions are to stay in your home for only 3 or 5 years, the ARM is better. In such a situation, you can make advantage of the lower rates during the initial years of ARM. Some people decide to make advantage of the low rate and when it adjusts they refinance, as they tried to do it before the crisis arose. But, the problem was that the values of their home decreased, and it was impossible to refinance. As a result, many of them faced foreclosure.
   But when you decide to be in your home for 10 years and more, it is possible to make advantage of all the benefits of the FRM.
   Another important factor that can influence your choice is your income. For example if you work in an area where your income is based on commissions, i.e. you are not getting a fixed amount of money, an ARM, that provides a smaller monthly payment, can make it easy for you to handle the monthly expenditures. But, if you generate a large amount of cash, you will pay down your principal balance. After that, when the interest rate decreases or your ARM should be reset, you can refund into the more suitable for you FRM.
   The last factor you should take into consideration is how much risk you can take. If you are a person who are always worrying about money, then ARM is not your deal. A lot of people trust FRM, because they know if tomorrow the payment will change.
   How to get the best Fixed Rate Mortgage? 
   Regardless of trouble the economy faces at a certain moment, there are solutions for you to make sure that you obtain the best rate. Eventually, the lower the rate, the more you will save should inflation lead to rate growth.
   1. Keep roughly a good credit rating. Your rate depends on how high you credit score is. Lenders are looking for people who have a FICO score over 750. For achieving this, you will have to pay your bills on time always and maintain the debt to credit ratio pretty low. Take a look at the copy of your credit report, which you can obtain free of charge at annualcreditreport.com, and check whether there are mistakes. If you find any errors, try to correct them immediately and make sure it is done before you apply for a mortgage.
   2. You should have 20% in cash to use as a down payment. You will have to demonstrate a lender that you are able to make a payment of 20% to be considered for the best rates.
   3. Avoid jumbo loans. A jumbo loan represents a loan that is higher than a “conforming” loan. The limit where a conventional loan ends and a jumbo loan begins is between $417,000 and $729,750. You must check the limits in your region and make sure that the loan you are applying for is under the conforming limit. In another way, a higher interest rate should be paid.
   4. Pay points. The points represent 1% of the loan amount and if you pay them you low the rate of your mortgage.
   5. Don’t become a debtor. Lenders carry out an in-depth analysis of your financial situation. In case you have a lot of debt as against to your income, lenders will consider you a high-risk borrower and not like a suitable candidate for a FR loan.
   Fixed rate mortgage documents
   The process of applying for a loan is simple, but it is better to be prepared. After you decide the lender you want to use, they will provide an application form. As an addition to the application fee, you will need the following items:
   1. The copies of bank records for some months, and the accounts numbers of any other bank accounts you have.
   2. A pay stubs that can prove your income.
   3. The individuals that are self-employed will need to provide 2 or 3 years of tax reports in order to show proof of income.
   4. Evidence of your rental payments or current mortgage in the form of cancelled checks.
   5. Proof of your down payment. It can be in the form of bank statement where you are holding the funds.
   Locking your rate
   After you find the most favorable terms and interest rate, you have to make sure they are available by the time of closing. Taking into account that interest rates change every day, it is possible that your rate increases. It is also possible that the rate can drop, in such cases only you can decide how to deal with this risk. Once you like what you see, it would be better to ask the bank to provide you with a lock-in commitment, which generally applies for 30 to 60 days.
   Once you choose to lock in your rate, make sure you get it in writing. If there is any dispute about the rate, an oral commitment from a lending expert won’t make the deal. Some loan officers may impose a fee for locking in a rate, and may not refinance it if the loan does not close within specified period of time.
   The lock-in period should give time for both you and the bank in order to get all the approvals for closing. In case you don’t close within the specified period, you can lose the interest rate and points. If the lock expires, you will need to start the process again, depending on the prevailing interest rates at that time.
   Closing Expenses
   Besides knowing the interest rate and the term of the loan, you also must know how much the loan will cost. Within 3 days of your application for a loan, the bank will provide you with a Good Faith Estimate (GFE) that will show you the estimate of your closing expenses. Nevertheless, it represents only an “estimate” and the costs can change significantly by the time you close. Here are some pieces of advice that will help you determine your closing costs.
   1. Points. If you want to reduce your rate, you can have the option to pay points, i.e. some fees paid to the lender. Each point represents 1% of the mortgage amount. The more points you pay, the lower the rate gets. You should always ask the lender to offer you a quote for the actual dollar amount contrary to the number of points, thus you will easily understand what you will be paying. You should pay the points at closing.
   2. Application and Underwriting fee. It is the cost of loan processing. It should also include the payment of you credit report.
   3. Appraisal fee. The bank will ask an appraisal in order to determine your home value, and at closing you will have to pay a fee.
   4. Title insurance. You will have to pay for a title search and insurance with every mortgage. The company will carry out a research to make sure there aren’t any liens on your property as well as will insure the lender if any mistakes occur.
   5. Other expenses. You may be asked to pay some additional costs such as tax service, recording fees, flood certification, pest inspection, and a survey.
   6. Attorney’s Fees. You will have to pay for your attorney and for the bank for theirs.