Fixed or Adjustable: Which is Better
Borrowers, especially first time buyers, are often surprised at the number of decisions they have to make before and during the loan approval process. Beyond the mortgage, they’re evaluating even more options. Where do they want to live? What type of house do they want? Is a downtown condo a better option than a single family home? How close to work do they want to live and how much should they pay for their new home? You can easily see how this process can be a bit overwhelming even for a seasoned home buyer. But once these questions are answered, they must also decide what type of mortgage is best for them and whether a fixed rate loan or a hybrid is the better choice.
If borrowers anticipate keeping the property for an extended period of time then a fixed rate loan might be the best choice. Fixed rate loans are just that: the rate never changes during the course of the mortgage. When rates are at relative lows, like they are now and the borrowers don’t have any intentions of moving or otherwise selling the property, fixed rates have the advantage. Fixed rate loans can be found in loan terms from 10 to 30 years.
A hybrid is really an adjustable rate mortgage, or an ARM. An ARM has three components, an index, a margin and caps. The index is the initial rate and is typically tied to a 1-Year Treasury. The margin is then added to the initial rate to arrive at the fully indexed rate. For example, if today the 1-Year Treasury is 1.25 and the margin is 2.00, the rate the borrowers would base their payment upon would then be 1.25 + 2.00= 3.25, or 3.25 percent and remain there for one year until the next adjustment period. Caps are put into place to protect the borrowers from any potential major swings in the index. A common cap is 2.00 which means the newly adjusted rate can’t be higher than 2.00 over the previous rate.
A hybrid is so-called because it acts like both a fixed rate and an ARM. A hybrid has an initial fixed rate for say three or five years before turning into an ARM. Why do borrowers choose a hybrid? Hybrids offer lower initial rates compared to a fixed rate loan. Let’s say that someone decides they’re likely to move within five years or so. They look at a 7/1 hybrid, a loan fixed for the first seven years, and a 30 year fixed rate and see the hybrid has a slightly lower interest rate. In this example, perhaps the hybrid would be the better choice. And even if they do stay longer than seven years, let’s say they stay for another year or so, because of the interest rate caps, they’re still protected just in case interest rates in general have risen over time. In this scenario, they’ve enjoyed lower monthly payments with the hybrid compared to the fixed rate product.
What should you do in your situation? Your loan officer can run as many scenarios as you like comparing monthly payments with current fixed rates of your selected loan term. You’ve got a lot of decisions to make during this process, but the “fixed vs. hybrid” is really an easy one.