The Best Home Loan Rate - Fixed or Adjustable?

The recent mortgage mess has highlighted just how important it is to fully evaluate home loan rates before signing on the dotted line. Specifically, for the best home loan, prospective borrowers need to carefully compare fixed-rate and adjustable-rate loans, even if ARMs carry a lower initial interest rate.

Best Home Loan - Plusses and Minuses

With a fixed-rate mortgage, you pay the lender the same, fixed interest rate over the life of the home loan, which usually will be 30 years but could be 15 or 20 years.

Fixed-Rate benefits include:

• No change in monthly principal and interest payments regardless of fluctuations in interest rates
• More stability may give you "peace-of-mind"

Fixed-Rate considerations include:

• Higher initial monthly payments compared to those of adjustable rate mortgages
• Less flexibility

With an adjustable-rate home loan, or ARM, your interest rate may be fixed for a certain time period but later will periodically rise or fall based on a market index. Although early payments at "teaser rates" may be lower with an ARM, the interest costs later on can go up significantly.

ARM benefits include:

• Initial payments lower due to lower beginning interest rate, usually about 2 percentage points below the fixed rate
• Ability to qualify for a higher loan amount due to lower initial interest rates
• Lower interest payments if the interest rate drops over time
• Interest rate caps limit the maximum interest payment allowed for the loan

ARM considerations include:

• Initial lower interest rate and monthly payments are temporary and apply to the first adjustment period. Typically, the interest rate will rise after the initial adjustment period.
• Higher interest payments if the interest rate rises over time

"Frequently, the fixed-rate home loan is cheaper and safer in the long run," says Janet Kincaid, FDIC Senior Consumer Affairs Officer.

Also carefully evaluate your ability to make payments throughout the life of a home loan. The best home loan is worthless is you can't make the monthly payment. "The mortgage loan originator should conduct a realistic assessment of your ability to repay, especially with an ARM, including the highest possible payment under the terms of the loan," says Victoria Pawelski, an FDIC Policy Analyst. "An unrealistic assessment based on a low, introductory payment can lead to payment shock and, for some people, a very costly foreclosure."

To identify your best home loan, start by asking for a side-by-side comparison of what you would pay each month with both fixed- and adjustable-rate mortgages and assuming that the ARM's interest rates will rise to their maximum levels. You'll most likely see that after, say, three years, the ARM could start costing more than the fixed-rate option, and eventually could be far more expensive.

Best Home Loan Rates - Don't Forget Taxes and Insurance

Real estate taxes and insurance can add significantly to your monthly payments, and they are likely to rise in the future, so it's best to include those costs in your review. (Even though a lender may not require escrow payments for taxes and insurance as part of your mortgage, it's important to factor those costs into your comparison.) Your best home loan rate will also take into account any fees you would owe the lender and other service providers. Also find out if there will be prepayment penalties for paying off the loan early, because these can be very costly if you want to refinance or sell your home.

The Best Home Loan Offers No Surprises

Be wary of a mortgage with payments that can increase substantially. "In the worst cases, people lose their homes when they take on mortgages they can't afford," says Sandra Thompson, Director of the FDIC's Division of Supervision and Consumer Protection.

Best examples of home mortgages at risk of rising payments include:

• Interest-only loans, for which the borrower pays only the interest — not principal — for the first three, five or more years but then must either pay the loan off entirely or start making much higher payments to repay the principal. The potential risks are significant, especially if the interest rate has gone up and the consumer can't make the new, higher payments.
• "Payment option" ARMs, meaning the borrower has several choices on how much to pay from one month to the next for a set time period. These ARMs may be appropriate for people whose monthly income fluctuates, but if they defer too much interest their costs will go up significantly (because they'll be paying interest on a higher loan amount, perhaps for many years). "Borrowers risk defaulting on their loan if they can't afford the higher payments and if they have problems switching to a better loan," says Luke W. Reynolds, an FDIC Community Affairs Specialist.
• Hybrid ARMs, which charge a low fixed-interest rate in the early years and generally result in a higher payment thereafter. "These loans allow the consumer to place a bet on the direction of interest rates over the term of the loan, and it is very risky to take a bet when your home is on the line," adds Reynolds. 

On a final note, if you decide to go with an ARM, you can best protect against rising interest rates in the future by adding a "conversion option" to your loan agreement. This would allow you to switch to a fixed-rate mortgage in the future. There will likely be a set fee involved for such a switch, but the option gives you a safety net in an uncertain future.

Credits: FDIC Consumer News and Ginnie Mae