June 30. 2018 6:11PM

Marc A. Hebert's Money Sense: A fixed vs. adjustable rate mortgage

By MARC A. HEBERT


A mortgage can last 30 years or sometimes longer, so choosing the right one from the start makes sense. (Metro Creative Connection)

Homes come in all shapes and sizes: large, small, old, and new. Like homes, mortgages also vary. Deciding on the right type can be a daunting task.

A mortgage can last 30 years or sometimes longer, so choosing the right one from the start makes sense.

One of the basic decisions is whether to use a fixed-rate mortgage versus an adjustable-rate mortgage (ARM). Fixed-rate mortgages are just as the name implies - the interest rate on a conventional fixed-rate mortgage remains the same throughout the entire length (term) of the loan. Given this, the monthly payment remains the same.

Many homeowners like the idea of a stable payment. It does make budgeting that much easier, especially when projecting expenses many years out. The fixed nature of the payment is good for homeowners with a low tolerance for risk.

But the fixed nature of the rate does have its downside. Mortgage rates rise and fall. If they rise, the rate on a fixed-rate mortgage won't rise with them. On the flip side, if interest rates go down, the mortgage payment won't. This translates into a higher payment than the amount that a homeowner might otherwise pay.

Refinancing the loan by taking a lower-rate loan to pay off the higher-rate one may be a possible solution. Doing this doesn't always make sense, however. The drop in interest rates needs to be reviewed against the cost of the loan refinance. Remaining in the home to recover the costs needs to happen if refinancing is to be a viable option.

Another choice is an ARM. An ARM is designed to deal with fluctuating interest rates. The monthly payment could change based on the current rate. An example is a 5/1 ARM. This loan has a fixed rate for five years, and then its rate would reset once per year for the remaining 25 years of its term, assuming a 30 year mortgage. The "5" is the period the introductory rate lasts. The "1" means the rate can adjust every year after that, subject to restrictions called "floors" and "caps," as written into the contract.

The adjustments are based on an index rate set by market forces. The lender takes the index rate and adds an agreed-upon number of percentage points, called the margin. This becomes the new interest rate on the loan.

Please be aware that the payment may be capped but not the interest rate adjustment. The payment cap can result in negative amortization during periods of rising interest rates. In other words, any interest not reflected in the payment is added on top of the loan balance. Even though monthly payments are made, the loan balance increases.

Sometimes the initial interest rate is lower for an ARM than a fixed-rate mortgage. It is the low initial cost that makes the ARM appealing and may provide the borrower with the ability to purchase a larger home. But it is the uncertainty in future payments that can be scary. As interest rates are unpredictable, the future payments are unknown.

When would a homeowner use an ARM? If there is a belief that interest rates are going lower or the plan is to stay in the home for only a short period of time, an ARM may work. Perhaps it is your first home and the plan isn't to stay in it for a very long time.

As with any contract, be certain to review and understand the provisions prior to signing the document. The terms of an adjustable-rate mortgage are often more confusing than a fixed-rate mortgage.

Don't be naive and think that interest rates can't increase substantially. Your loan terms and rates need to be based on individual circumstances and long-term financial plans.

Marc A. Hebert, M.S., CFP, is a senior member and president of the wealth management and financial planning firm The Harbor Group of Bedford. Email questions to Marc at mhebert@harborgroup.com. Your question and his response might appear in a future column.