Mortgages can have either fixed or adjustable rates, or sometimes a combination of the two.
The interest you owe on a mortgage loan may be calculated just once or adjusted many times. With a fixed-rate loan, the total you’ll owe is determined at closing. With an adjustable-rate loan (ARM), the amount changes as the cost of borrowing changes.
Choosing between a fixed-rate or an adjustablerate mortgage isn’t an all-or-nothing proposition. In fact, there are hybrids that offer certain advantages of each type while softening some of their drawbacks.
Among the most popular are mortgages that offer an initial fixed rate for a specific period, usually five, seven, or ten years, and then are adjusted. The adjustment may be a one-time change, to whatever the current rate is. More typically, the rate changes regularly over the balance of the loan term, usually once a year.
One appeal of the multiyear mortgage, as these hybrids are often called, is that the borrower can get a lower rate on the fixed-term portion of the mortgage than if the rate were set for the entire 30 years. That’s because the lender isn’t limited by a long-term agreement to a rate that may turn out to be unprofitable.
The lower rate also means it’s easier to qualify for a mortgage, since the monthly payment will be lower. That’s a real plus, especially if you’re a first-time buyer.
For people who plan to move within a few years, especially if it’s within the period during which they’re paying the fixed rate, there’s the added appeal of paying less now and not having to worry about what might happen when the adjustable period begins. In fact, the typical mortgage lasts only about seven years. Then the borrower moves or refinances and pays off the balance.
The introductory rate you pay for the first months of an adjustable-rate mortgage is almost always lower than the actual cost of borrowing the money. What it means for the borrower is not only a few months of relief but also lower closing costs. The effect is to make mortgages more accessible to more people.
What it means for the lender is being able to adjust the rate upward when the introductory period ends, while staying competitive with other lenders.
However, in evaluating whether you’ll be able to afford the mortgage, the lender must calculate your monthly payment at the highest amount it could possibly be within the first five years of the term, not what that amount would be at closing.