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Adjustable or Fixed -- Which Loan Is Best For You?

In recent months mortgage rates have plummeted and plunged to depths rarely seen.

"Fixed-Rate Mortgages Lowest on Record," said a recent Freddie Mac news release.

If you're a borrower the news on the mortgage front has only been good. There can't possibly be a mortgage shortage when rates are in the dumper -- low rates have to mean the supply of cash is outstripping loan demand.

The catch is that not all loan rates are equally low. The Freddie Mac "all-time record lows" release said the typical 30-year fixed rate loan was priced at 4.01 percent while at the same time the 1-year Treasury-indexed adjustable-rate mortgage (ARM) averaged 2.83. In both cases points are extra.

There's a big financial difference between these two rates -- and also risks if rates change over time.

Imagine that you can get these rates for a VA mortgage. If you borrow $150,000 over 30 years at 4.01 percent your cost for principal and interest will be $725 per month. With a one-year ARM the payment will be $619 per month.

With the two mortgages above the ARM borrower will save $106 a month compared to the fixed-rate borrower. If the ARM rate remains in place for five years a borrower will save $6,360.

Saving more than $6,300 is a big deal so isn't the ARM the automatic choice?

The real answer depends on your tolerance for risk.

ARMs v. Fixed-Rate Mortgages

No doubt the numbers are right but context is also important and in this case the context is this: What happens after five years?

The objective answer is that we don't know. It's possible that mortgage rates in five years could be the same as today and it's also possible that they could be lower.

Possible. But not certain. It's equally possible that mortgage rates down the road could be higher.

Whether rates go up or down is not an issue for fixed-rate borrowers. Their monthly payment for principal and interest stays rock-steady and unchanged.

For the ARM borrower the story is different. If rates remain the same or decline, no problem.

But what happens if rates rise? Truth is, when Freddie Mac says we've hit all-time record lows they're not kidding. For those of us who can remember when an 8-percent mortgage was the norm and far better than financing at 10 percent, today's rates are little short of miraculous.

The catch is that today's rates could rise. And while steady or lower rates are not an issue for the ARM borrower, higher rates could be.

Our $150,000 ARM had 2.83 percent interest for the first five years. At the end of five years the loan balance would be $132,942. We now have 25 years remaining on the loan term.

If the new interest rate is 6 percent -- a bargain by historic standards -- the new monthly payment will be $857. An 8 percent rate would mean a monthly payment of $1,026.

Make the Right Choice for You

Are new and perhaps higher ARM costs something to be feared? For many households such steeper costs might be very acceptable. And five years from now bigger mortgage payments may not be a problem at all, especially if incomes rise.

But we live in a changing world. Incomes which once seemed safe and secure are now in question. People with lots of experience and training are losing their jobs to downsizing, rightsizing and outsourcing.

And many of the people who now face foreclosure became exposed to financial hardships in the first place because they opted for mortgages with higher future payments, payment they thought they could make or that they would never pay because the property could be profitably sold before monthly costs went up.

So should you get a fixed rate loan or an adjustable? Only you can answer, only you can judge your risk tolerance.