While mortgage interest rates remain near historic lows, they have been slowly rising over the last year, increasing the cost of the popular 30-year loan for borrowers.
Home buyers concerned about higher rates have a few other options they can consider: an adjustable rate mortgage (ARM), which provides an initial lower monthly payment, or a 15-year fixed rate mortgage, which has a higher monthly payment but reduces the amount of interest paid over the course of the loan.
A Shot in the ARM
The ARM typically starts out at a lower interest rate than the classic, 30-year fixed rate. After an initial period, typically 5, 7 or 10 years, the interest rate adjusts over the life of the loan.
There are several different types of ARMs, but one of the most popular is the 7/1, which stays stays at the same rate for the first seven years and then adjusts yearly thereafter.
For example, if you have a 7/1 ARM at a 3.5 percent intererst rate, you will pay interest at that 3.5% level for seven years. After that, the lender applies a new rate based on an indexed interest rate, plus a margin, to give you a different rate.
“After the fixed period, the rate can increase each year, but the good news is that there are caps on how high that rate can go,” said Peter Boomer, head of mortgage distribution for PNC Bank. “The opposite may also be true: it is possible the rate will decline if the forces in the market are pointing that way. The best advice is to check with your lender for the details.”
What You Need to Consider
Boomer said it’s important to know how long you expect to be in your home.
“The national average is seven years before homeowners sell or refinance, which is why the 7/1 ARM is so popular,” he said. “If you expect to be in a home for fewer than 10 years, then you may want to consider an ARM.”
Boomer suggests talking with a mortgage loan officer about whether an adjustable rate may save you money over the life of your loan. Many people like the idea of that lower rate to start out, while others prefer the peace of mind of knowing their rate will remain stable for the term of a traditional mortgage.
For traditional mortgages, refinancing remains a viable option if interest rates fall in subsequent years.
“It’s important to remember that mortgage rates rise and fall over time. It may be well worth it to consider an ARM because over time there may be savings, as opposed to the cost of refinancing,” Boomer said.
You should look at your own family, job, future and goals to decide whether financing your home with an ARM makes sense. Your family may grow, you may get a new job and relocate, you may even be looking to downsize for retirement or you may face other changing financial conditions.
Taking a Cut at the Term: 15-Year Mortgage
Another alternative is the to go with a shorter term fixed-rate loan, the most popular being 15 years.
According to Boomer, while a 15-year mortgage will have a higher monthly payment than a 30-year fixed, the interest rate is typically lower and you pay back the principle faster, which means you can save money on interest over the length of the loan.
“The good news for consumers is that they have many financing options available to them. Home buyers should talk to their loan officers to discuss the many options to fit their individual situation,” he said.
Regardless of the route you choose, owning a home can still be the path to keeping your American dream alive, and exploring your options can help you to more easily achieve it.
“People should look at their own picture, their family, their job and their future to decide which direction makes the most sense for them.” – Pete Boomer
