How do you decide which is the best mortgage for you: a fixed-rate or adjustable-rate mortgage?

Many home buyers are tempted by the low initial costs associated with adjustable- 
rate mortgages (ARMs), while many are turned off by the degree of risk involved. Fixed-rate mortgages offer borrowers interest rate and payment amount security, but are often more expensive.

The advantages of an ARM

ARMs feature lower rates and monthly payments for an initial amount of time. Because lenders are looking at the lower payment when qualifying borrowers, many homebuyers can afford larger homes than with a fixed-rate mortgage.

ARMs allow borrowers to take advantage of falling rates without having the cost and hassle of refinancing. Borrowers simply have to sit back and watch the rates and their payments go down.

Borrowers that choose ARMs are able to take the difference in payments and invest it in a higher yielding investment.

If you plan on living in your home for a short amount of time, consider an ARM that has an initial fixed-rate period longer than you plan to own the home. This gives you the benefits of the initial low rate, and if you move on schedule, you won't face the adjusted rates.

The disadvantages of an ARM

While rates can go down, they can also go up. Way up. A 6% ARM can turn into an 11% ARM in as little as three years. When the interest rates rise, so do the monthly payments.

In general, the rates of ARMs usually adjust to a higher rate than the going fixed-rate level in almost every mortgage. This can happen even if the overall rates on the market don't change. The reason behind the increase is often the ARM has initial rates that are set artificially low.

Many borrowers are shocked by the first adjustment. The first adjustment is usually not limited by any caps. For example, you have an ARM with an annual cap of 2% and a lifetime cap of 6%. The annual cap may not apply to your first adjustment. If interest rates are skyrocketing, your first adjustment could take you from 6% to 12% overnight.

There are many details that make ARMs difficult to understand. There are margins, caps, adjustment indexes and other details, so many borrowers are confused or fooled by shady mortgage companies. Many borrowers simply do not understand what an ARM is and how the payment amounts can change over time.

There are certain ARMs, called negative amortization loans, which end up with the borrowers owing more than they took out at closing. These mortgages allow the borrower to make a minimum payment that is less than the accrued interest. The amount not paid is simply tacked onto the principal balance, which grows over time.

The advantages of fixed-rate mortgages

Fixed-rate mortgages offer security to homebuyers. The interest rates are fixed and the monthly payments remain constant. The borrower will have the same monthly payment for the life of the mortgage, even if market rates increase.

These mortgages allow people to manage their money with more certainty when budgeting and planning. They know that their mortgage costs will not fluctuate over time.

Fixed-rate mortgages are simple to understand and are ideal for first-time buyers.

The disadvantages of fixed-rate mortgages

If interest rates see a substantial decrease, the fixed-rate mortgage holder must refinance to take advantage of the lower interest rate. Refinancing often means thousands of dollars in closing costs and time spend applying and qualifying for a new mortgage.

In some areas of the country, homes are extremely expensive for the average homebuyer. Many find that fixed-rate mortgages are too expensive for the type of home they want to purchase.

Fixed rate mortgages are usually straightforward, varying little from lender to lender. ARMs are usually customized to individual borrowers, while most fixed-rate mortgages aren't.

In addition to the above factors, you should ask yourself four questions when deciding what type of mortgage is best for you:

1. How long do you plan on owning the home?

If you only plan to own the home for a few years, it makes sense to have a lower-rate adjustable mortgage. You can often find a reasonably priced 5/1 mortgage. You will benefit from a lower payment and interest rate, allowing you to build up your savings for your next home. Plus, you will be moving before the adjustable rate period begins, which removes you from any risk associated with adjustable-rate mortgages.

2. How frequently will the ARM adjust and when?

You have to look at the terms of the ARM when considering if it is the right choice for you. After the initial fixed period, most ARMs will adjust once a year on the anniversary of the mortgage closing date. The new rate will be set 30 to 45 days before the anniversary, depending on your lender's terms. The new rate will be calculated using the specified index in your mortgage documents.

Some ARMs will adjust every month. That may be too volatile for you. In such a case, a fixed-rate mortgage may be best for you.

3. What are interest rates doing?

You have to look at where interest rates are and where they are expected to go when considering an ARM. When rates are high, ARMs give borrowers lower initial rates and the benefits of owning a home. If they are expected to fall, the borrower has a decent chance of getting low payments without having to refinance.

If rates are low and rising, fixed-rate mortgages usually make more sense. After all, 7% is a good rate to borrow money at for 30 years, even if it is higher than many ARMs initial rates. Remember, those rates have a good chance of going up.

4. Can you afford the payment if rates go up?

You can't only look at today's monthly payment when considering an adjustable-rate mortgage. You have to look at where the monthly payment could be next year, ten years from now and even 25 to 30 years from now.

For example, on a $150,000, one-year adjustable-rate mortgage with 2/6 caps, your 5.75% ARM has the potential of one day becoming an 11.75% mortgage. When interest rates go up, your payment goes up.

The increase in your payment can be quite shocking. For the first year, you would pay $875 a month. When your payment adjusts the second year, it can only adjust by the limited 2% to 7.75%. That increases your payment to $1,075. That is a difference of $200 a month. If you stretched to get into the home, $200 a month could be a lot of money.

The third year, the interest adjusts by another 2% to 9.75%. This time, your payment goes up to $1,289 - an increase of $414 a month.

The fourth year, the interest could hit the 6% lifetime cap, coming in at 11.75%. Your payment is then $1,514 a month. That is an increase of $639 a month, quite a lot of money when you thought you were getting lower payments.

With a fixed-rate mortgage, your payment is the same in four years as it is today. If you total all of the payment up over four years, you will spend $57,036 dollars towards interest and principal. If you had simply taken out a fixed-rate mortgage at 7.75%, your total payments would add up to be $51,600. The ARM cost you $5,436 more than the fixed-rate mortgage in only four years.  Experts say that when mortgage rates are moderately low, fixed-rate mortgages are the way to go, even if you only plan to live in the home for a few years.