Both the 30-year fixed-rate mortgage and 5/1 adjustable-rate mortgage are payable in 30 years. That’s their only common ground; both loans are structured differently because of their interest rate type. Surely, the 30-year FRM has its strengths (and weaknesses) as does the 5/1 ARM. Which purchase mortgage is for you?
Purchase Mortgage Choice A: 30-Year FRM
Belonging to the stable fixed-rate mortgage family, the 30-year FRM has the same interest rate on the amount borrowed over a repayment period of 30 years. The result: stable, low monthly payments.
For a $200,000 30-year FRM with an interest rate of 4.25%, you’ll make principal + interest payments of $983.88 every month. Expect to make practically the same fixed monthly payments through the life of the loan.
Compared with its 15-year fixed-rate counterpart, the 30-year FRM has lower payments. It fits well into the budget for homeowners. How does it work?
- At the onset of the 30-year FRM, much of the monthly payment goes to the interest portion of the loan.
- As the loan progresses, more goes toward the principal of the loan until such time as it is paid off.
Purchase Mortgage Choice B: 5/1 ARM
The 5/1 ARM has a rate that (i) initially remains the same for the first five years (known as the fixed period) and (ii) adjusts once annually for the next 25 years.
Five/one ARMs boast of rates lower than fixed-rate mortgages. This lower introductory rate leads to lower payments that are attractive to homebuyers looking to save early on.
What follows after the fixed period is monthly payments either going up or down, depending on the market forces and financial indexes tied to the rate. ARMs do have rate caps that control how high they can go. And they can go low too.
30-Year FRM vs 5/1 Year FRM
Now, let’s weigh the merits and risks of each mortgage program.
Low vs Lowest. The weekly mortgage rates data gathered by Freddie Mac show the 5/1 ARM as having the lowest rate next to the 15-year FRM and the 30-year FRM. Some homebuyers who wish to make lower payments at the start of the loan turn to 5/1 year ARMs.
Stability vs Uncertainty. ARMs offer uncertainty when the fixed period is over. When the rate climbs up, expect the payments to do the same. The ARM rate is exposed to forces beyond our control that one can only speculate but never predict its movement. If you lock into a fixed rate, expect to keep making the same payments throughout the loan term.
Payoff or Refinance. The 30-year FRM can be costly to keep because of its higher interest rate and a larger interest cost. To mitigate these costs, some homeowners refinance to a lower rate or shorten their loan period by half and make higher payments. There are other homeowners who put extra payments toward the principal to pay off the loan faster, ideally without a prepayment penalty.
Initially, the 5/1 ARM is less costly to maintain and homeowners who took them out are usually those who:
- Plan to stay less than five years in the home, or
- Move out, sell the home or repay the loan in full before the five-year period is up.
Some homeowners, fearing the risk of drastic changes in their monthly payments and want to stay longer in the home, opt for the stability of an FRM by refinancing.
Another tip in choosing the suitable purchase mortgage product is to consider the closing costs and weigh them against how long you plan to stay in the home. Choose wisely.
Justin McHood is a managing partner at Suited Connector and has been recognized by national media outlets as a financial expert for more than a decade.