Choosing between fixed rate and ARM


July 21, 1996|By Michael Gisriel

Dear Mr. Gisriel: I am getting ready to buy a home this summer. I've noticed that mortgage interest rates have fallen recently. My question is, do you recommend that I get a fixed-rate or adjustable-rate mortgage (ARM)?

Lenny Stabler

Glen Burnie

Dear Mr. Stabler: The key questions are: How long do you plan to live in the home? And are you willing to risk rates going up?

The interest rate on the ARM -- though cheaper initially -- has a risk of rising, unlike the fixed-rate loan. Most conventional ARMs have a lifetime cap of 6 percent and 2 percent a year -- that is, the interest rate on an ARM can rise 2 percent a year and 6 percent over the life of the loan. The interest rate on an ARM -- after the introductory rate expires, usually after a year -- is based on an index rate, such as the one-year Treasury bill rate, plus a margin, normally 2.75 percent.

With a one-year Treasury rate of 4.375 percent, the ARM would be 7.125 percent. In contrast, a 30-year fixed-rate loan today is about 8.25 percent.

If the ARM increased by 2 percent -- the maximum -- each year, in about 4 years you will have paid the same amount of principal and interest on both types of loans.

At the end of seven years, the ARM, if it is at the maximum rate, would cost you about $6,000 more in interest than the fixed rate.

Your decision should be based on how much risk you are willing to take and how long you expect to live in the home.

You should also explore other ARM products -- like a 5/1 or 7/1 ARM if you plan to live in this home more than 6 years. These loans have fixed rates for five or seven years -- usually below 30-year fixed rates -- and then convert to an ARM.

A fixed-rate loan gives you the same principal and interest payment during the entire time you live in the home. And an ARM offers a lower rate in the beginning years but possibly higher principal and interest payments later.

Dear Mr. Gisriel: Should my husband and I make a larger or smaller down payment on our new home purchase? If possible, we don't want to make mortgage payments for 30 years. What do you advise?

Catherine Arminger

Forest Hill

Dear Mrs. Arminger: Generally speaking, large down payments on homes are not the most productive use of investment dollars. Instead, why not make a smaller down payment and take out a shorter-term mortgage such as a 15-year fixed-rate loan. You could then save the additional cash for emergencies or, better yet, invest it somewhere else (e.g. a stock mutual fund) for long-term growth or retirement needs.

Pub Date: 7/21/96

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