Fixed Rate vs. Adjustable Rate Mortgages

Doing a home refinance involves making several important decisions. One of the biggest things to decide is whether it makes sense to get a fixed-rate or an adjustable-rate mortgage (ARM).

While you may have heard a lot of reasons not to get into an ARM, it's important to examine your specific situation to make the right choice. Here are some things to consider when choosing between a fixed-rate mortgage and an ARM.

Compare Mortgage Rates

Anyone refinancing wants to find the lowest mortgage rate possible. In general, ARMs have lower mortgages rates at the beginning of a loan term than fixed mortgages, which carry the same rate for the entire term. ARM rates can be fixed for the first one to ten years before adjusting. Refinancing into an ARM can save you a bundle of money early on in your loan, but because interest rates fluctuate, you risk your interest rate rising. Mortgage rates on ARMs can also fall depending upon how the index the loan it is tied to moves.

Monthly Mortgage Payments

Have your mortgage broker run the numbers on an ARM so you can see how high your mortgage rate could rise over time. Would you be able to afford the higher payments with your current income? Do you have a reasonable expectation that your income is going to rise over time, making any changes in your mortgage payment more manageable?

Use caution when looking at future income. Even if you feel upbeat about your financial future, it's not impossible that you could experience a sudden layoff as so many Americans have recently. Working in an industry that is associated with higher-than-normal downsizing could be a red flag when it comes to getting a mortgage with an adjustable rate.

Do You Have Other Debts?

Carrying too much debt can impact your ability to repay your loan after refinancing. Even if you lower your monthly payments with a mortgage refinance, you could end up over your head if you run up a bunch of credit card debt or buy a new vehicle.

Look at what your debt-to-income ratio would be after refinancing. Total up all your monthly debts (mortgage costs should include loan payments, property taxes, and homeowners insurance) then divide that by your monthly income.

For instance, if you earn $4,000 a month and have debt payments that total $1,200 a month, you have a debt-to-income ratio of 30%, well under the 38% ratio that is about as high as many mortgage lenders like to see when approving a loan. You need to be comfortable that your debt-to-income ratio would still be manageable even if the interest rises on an ARM.

Do You Plan to Sell Soon?

An ARM could work if you plan to move before it resets. You could take advantage of a few years of lower monthly payments, then sell your house and pay off the mortgage. Keep in mind that if the housing market in your area is weak, it could take longer than you anticipate to sell your property.

In anticipation of a move in a few years, set up a timetable for completing any repairs or upgrades that are likely to impress buyers. You don't want to be stuck at the last minute with a home you can't sell and a mortgage rate that jumps so high you begin to struggle financially.

Summary

• When refinancing a mortgage, it's important to decide if you want a fixed-rate loan or adjustable-rate mortgage.
• The interest rate on an ARM changes periodically and can go up or down depending upon the index it's tied to.
• If an ARM adjusts up, are you going to be able to afford the monthly mortgage payments?
• What is your debt-to-income ratio and what would it be after refinancing? It's important that you are still able to make monthly mortgage payments even if interest on an ARM rises to the maximum level it can.
• An ARM could work for you if you plan to sell your home before the interest rate rises.