Everyone who opts for their first loan is torn between the two options available to them. It is a difficult decision to choose between a variable interest rate plan and a fixed interest rate plan. If you are also going through the same turmoil, this article is meant for you. Before explaining you the pros and cons of each type of loan, let us define them. It helps you to have a vague idea about what exactly are we talking about before you opt for any one of them.
As the name suggest a mortgage loan with a variable interest rate, is one where the interest you need to pay for the outstanding amount changes as per the changes in the market rate. As a result, the payments you ought to pay to the lender also varies.
The case with Fixed interest rate loans is a bit different. The Interest rate and the monthly payment that you have to pay back to the lender are fixed. It does not depend on the market fluctuations.
The answer to the compound question whether a variable interest loan is better or a fixed interest rate one is entirely dependent on you. After all it is you, who will be paying the money back along with the interest for the home you will purchase. Let us help out to figure out a right plan for you taking an example.
According to the leading banks, the mortgage rates in March 2014 for 30-year fixed were 4.5%,[1] similarly for 15-year fixed were 3.51%[1] only. Varying rate mortgage plan a.k.a Adjustable Rate Mortgage(ARM) are of different types. They are of various kinds with 5/1 ARM being the most popular. It is followed by 3/1,7/1 and 10/1 ARM when it comes to people’s choice[1].
Let us talk about the 5/1 ARM. In 5/1 ARM, there is a fixed interest rate according to which the borrower has to pay the lender back for the initial five years, also known as the introductory period. Once this period is over the rate of interest is adjusted every year for the remaining loan duration.
As in March 2014, the rate of interest for the introductory period of 5/1 ARM is just 3.3%[1]. After the initial period is over the rate of interest is varied according to the changes in the U.S Treasury rate. There is an added advantage of a 2-2-6 cap structure associated with 5/1 ARM as well. It means that once the introductory period is over the rate of interest can increase only by 2% maximum (Even if the changes in the U.S. Treasury rate is more). Also, the maximum rate of interest can never increase more than 6%. It means that if the rate at which you opted for the loan under 5/1 ARM is 3.3%, it can never cross 9.3%.
Now, that you have an idea of what the loan structures are like, let’s see how much does the monthly payment for the loan comes out to be. Assuming that you took a loan of $200,000, to be paid back in a period of 30 years with 4.5% fixed interest rate. The amount that you have to shell out monthly will be just $1,013.37[2]. Now if we calculate the same amount for 5/1 ARM for the introduction period with the interest rate of 3.3%, it comes out to be $875.91[2].
This is the advantage of opting for 5/1 ARM, also if you are not sure whether the house you are buying will the perfect fit for you then 5/1 ARM model is best suited for your needs. But, if you think otherwise, then instead of dealing with the market fluctuations and changes the You should opt for a fixed interest rate mortgage plan.
It is also equally important to note that if the introductory period is longer, the difference of monthly amount that needs to be paid between FRM and ARM also becomes smaller.