When it comes to getting a home loan, many borrowers focus on getting a low interest rate. That makes sense because snagging a lower interest rate means that it ultimately costs you less to borrow money. However, high or low isn’t the only thing related to the interest rate that you’ll want to consider when choosing a home loan. There’s also the question of whether your rate should be fixed or adjustable. What is an adjustable-rate mortgage? Could this type of loan help you reach your housing goals?
What Is an Adjustable-Rate Mortgage?
As the Consumer Financial Protection Bureau explains, the names of these loans also offer basic definitions. A fixed-rate loan is a home loan with an interest rate that doesn’t change over the life of the loan. An adjustable-rate loan is a home loan with an interest rate that shifts, or adjusts, up or down in response to market factors.
How an Adjustable-Rate Loan Works
What is an adjustable-rate mortgage tied to? As Investopedia indicates, the rate of an adjustable-rate mortgage is tied to a specific index. In many cases, it’s the maturity yield on one-year Treasury bills, the 11th District cost of funds index, or the London Interbank Offered Rate. These loans generally start out with a low, introductory fixed rate. Then, the rate adjusts periodically. Both the length of the introductory fixed-rate and the frequency of the adjustment are determined by the terms of your specific loan. What else should you look for among the loan terms? Rate caps may come in handy. They place limits on how high the interest rate can go. You may also appreciate payment caps, which limit how high your monthly payment can climb.
The Advantages of Adjustable-Rate Mortgages
Why do homebuyers opt for adjustable-rate mortgages? As MillionAcres notes, these home loans do offer certain advantages:
- Interest rates may go down. Many buyers prefer the stability of a fixed-rate loan because they worry that interest rates might go up. However, interest rates can also go down. If you have a fixed-rate loan, you’d have to refinance to benefit from lower interest rates, and there’s a cost to that. With an adjustable-rate mortgage, you’d benefit automatically as your mortgage follows its terms and adjusts with the index.
- You’ll have a lower interest initially. One of the perks that attracts people to adjustable-rate mortgages is an initial interest rate that’s lower than the rate of comparable fixed-rate loans. Opting for this style of mortgage means that you’ll have a smaller monthly mortgage payment at first, so you’ll enjoy greater financial flexibility. You could use the time to rebuild your savings or add extra money to your payment to build your home equity faster.
- Short-term homeowners may see a better return. If you’re planning to remain in your home for a long time, a 30-year term can be a great bargain. However, if you’re planning a shorter stay, an adjustable-rate mortgage might offer the better deal.
The Drawbacks of Adjustable-Rate Mortgages
There are reasons why many borrowers steer clear of adjustable-rate loans. As NerdWallet reports, these loans do have their drawbacks:
- Interest rates may go up. If interest rates rise, your payments will too.
- Adjustable-rate mortgages are complicated. Fixed-rate loans are fairly simple when compared to adjustable-rate loans, which have more complex rules, structures, and fees.
- Prepayment penalties are common. If you plan on using an adjustable-rate mortgage for a few years before selling or refinancing, watch out. Some of these loans come with a prepayment penalty.
- The unexpected happens. Borrowers often plan to sell or refinance before the point in their loan’s life where the interest rate may rise substantially. Unfortunately, the unexpected happens, and plans change. Sometimes, borrowers are unable to sell or refinance when they hoped to.
Fixed-rate loans tend to be more popular, but that doesn’t necessarily make them the better option. Could an adjustable-rate mortgage be the right choice for your needs? To learn more about the pros and cons, talk to a loan expert at PrimeLending West Texas. To get started, contact the location nearest to you.