But before you can pack up and move in, you may need to secure a mortgage. This is often a long-term commitment — on average, homeowners expect to pay for their mortgages for 16 years1 — so it’s important to do your research and choose the mortgage that’s best suited to you.
Basically, when it comes to the mortgage interest rate you’ll pay, you have two ways to go, fixed or adjustable. Which is better? Well, that depends on your risk tolerance.
To help you think through your options, we’ve outlined the differences between fixed rate and adjustable rate mortgages:
Fixed rate mortgages are predictable.
With a fixed rate mortgage, the mortgage rate and payment you make each month (or whichever frequency you choose to pay) will stay constant for the term of your mortgage.
This means you’ll know exactly how much principal (the initial amount borrowed) and interest (the amount paid on the amount you borrowed) you’ll be paying on each scheduled mortgage payment throughout the term you select.
The downside? You won’t be able to tap into a lower interest rate — ensuring more of your payments go towards the principal and less to interest — if interest rates drop during the term of your mortgage.
What a fixed rate mortgage offers:
- Your “set it and forget it” choice
- Doesn’t change if the bank’s prime lending rate goes up or down
- Eases budgeting anxiety and increases predictability
- You may pay a premium for the stability
- You may miss out on potential interest rate drops
Tip: Interest rates vary widely depending on the term you choose. For example, the interest rate on a 30-year fixed rate mortgage would be considerably higher than the interest rate on a typical 10-year fixed rate mortgage.
Adjustable rate mortgages will fluctuate.
With an Adjustable Rate Mortgage (ARM), the interest rate stays the same for the first few years, and then begins to adjust at preset intervals, usually on the anniversary of your mortgage.
The most common adjustable rate mortgage is the 5/1 ARM. Here’s how it works:
- The initial interest rate lasts for five years (that’s what the “5″ means in “5/1”)
- After the first five years, the interest rate can change every year (that’s the “1″ in “5/1”)
To calculate your new rate, lenders use a benchmark interest rate, or index, that reflects general market conditions.
Cautious buyers often choose a fixed mortgage because it means they can budget for the length of their mortgage term without any surprises. Adjustable rate mortgages are less predictable, but could work to your advantage if you don’t expect to stay in your home for long and can handle a bit of risk and uncertainty.
Tip: Most adjustable rate mortgages include a cap limiting how much the rate can increase at a given adjustment interval, even if the index has changed by more.
What an adjustable rate mortgage offers:
- Your “let’s see what happens” choice
- Costs will be less if interest rates drop
- Offers the possibility to lock in a better rate down the road
- Your payments could increase if interest rates rise
- Monthly payments may change over time
- May increase your financial uncertainty
Tip: If you’re the type of person that always buys the extended warranty, then an adjustable rate mortgage is probably not for you.
What’s more common?
In recent years, the 30-year fixed rate mortgage has been the most popular home financing choice, according to Freddie Mac, the government-sponsored entity that works to help homeowners get mortgages. This option accounted for more than 85 percent of the home-purchase loan market in 2012.
How to choose what’s right for you
How do you feel about risk? A fixed rate mortgage means the lender takes the risk; an adjustable rate mortgage means you do. While the interest rate may be higher on a fixed rate mortgage, it will stay constant during your term so you can budget accordingly.
How do you feel about the current market? The difference between fixed and adjustable rates has narrowed considerably in the last few years, making fixed rate mortgages a bit more appealing. Interest rates have also been at historical lows.
Tip: Don’t assume you’ll be able to sell your home or refinance your loan before the rate changes. Going adjustable to save money in the short run — hoping to lock in a fixed rate “at the right time” — is really tough to do.
And what if interest rates rise? No matter which route you take, it’s crucial that you evaluate the impact of an increasing interest rate on your mortgage costs. For example, if interest rates go up by two percent, would you still be able to afford your monthly payment?
Here’s the good news: According to our research1, 83 percent of first-time home buyers plan to run a “stress test” on their mortgage in anticipation of a future rate hike.
That’s smart thinking. In fact, it always important to plan for the unexpected — you can start by establishing an emergency fund, for instance.
The next step
BMO Harris mortgage bankers are here to work with you to help you make the right decision based on your needs and your lifestyle.
Looking for more information about mortgages, refinancing or ways to make valuable home improvements? See our special offers available on our mortgages and home lending page.
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