Homebuying season is in full swing.
If you're on the hunt for a new home, you’ll want to decide how to finance it sooner rather than later. The two most common types of home financing are:
- Fixed-rate mortgage loans.
- Adjustable-rate mortgage (ARM) loans.
If you can qualify for a traditonal mortgage program as a doctor, that's great. If not, you'll probably have to opt for a physician loan program which is perfectly fine as well. Either way, you will likely be able to choose between a fixed rate and adjustable rate.
Each option comes with its own distinct advantages and disadvantages, so it’s crucial that you identify what's best for your financial situation. This article covers what you need to know as a doctor to do just that.
What is a fixed rate mortgage loan?
A fixed-rate mortgage loan is a type of home financing that carries the same interest rate for the life of the loan, typically 15 or 30 years. Let's take a closer look at its pros and cons.
Advantages of fixed rate mortgages
As we mentioned above, the interest rate on a fixed-rate mortgage stays locked for the entire life or “term” of the loan. No matter how the interest rate environment changes, the rate on a fixed mortgage will not increase or decrease.
So if you lock in a 4 percent interest rate at closing, that’s what you will pay each year until the loan has been paid off. This makes long-term stability and predictability the primary advantage of fixed rate mortgages.
Fixed rate mortgage loans are designed to protect borrowers from higher interest rates in the future. When the economy is in growth mode, long-term interest rates tend to increase, and the cost of borrowing typically rises as well.
Disadvantages of fixed rate mortgages
While long-term stability is certainly nice to have, it does come at a cost. This highlights the primary disadvantage of this home financing route:
Fixed-rate mortgages typically have higher interest rates than adjustable-rate mortgages.
This is because the lender is taking on more risk if interest rates rise in the future. Because of that risk, the borrower is essentially paying a premium for the that sweet stability over the life of the loan. The specific rate you receive from a mortgage lender depends on multiple criteria including factors like your credit score.
When a fixed rate mortgage makes sense
For borrowers that are planning to stay in a home for an extended period of time (over 10 years), the advantages outweigh the higher interest cost if rates rise in the future. Most common mortgage terms are 15 or 30 years, but some lenders may be more flexible in their offerings.
Bottom line: If you plan for a longer period of time and want to hedge the potential of rising interest rates, fixed rate loans may be a great choice.
What is an adjustable rate mortgage loan?
An adjustable rate mortgage loan is a type of home financing in which the interest rate is subject to change --- for better or worse. Now, let's examine the pros and cons of this option.
Advantages of adjustable rate mortgages
To reiterate, the interest rate on an adjustable-rate mortgage (ARM) is not fixed for the duration of the loan. It can and likely will fluctuate over time.
So why would anyone want to forfeit the stability of a fixed rate mortage for the unpredictability of an adjustable rate mortgage? One word --- savings. Borrowers who choose adjustable mortgage loans tend to secure lower initial interest rates than those who use fixed-rate loans.
As for the risk of rising interest rates, many ARM loans have caps on how much the interest rate can increase or decrease. These caps typically include both an annual limit and a lifetime limit.
For example, an ARM loan may specify that the maximum interest rate adjustment each year cannot be more than 2%, and cannot be more than 5% over the life of the loan. This would be written as a 2/5 cap.
In many cases, the interest rate on an adjustable rate loan may fixed for the first five to seven years before changing to match current mortgage rates. This rate adjustment typically happens once per year.
ARM loans are usually labeled with numbers to delineate the following:
- The length of the introductory fixed phase.
- The frequency of rate adjustments following the fixed phase.
For example, SoFi offers a 7/1 adjustable rate mortgage that has a fixed interest rate for the first seven years. After that, the rate changes annually based on the 1-Year LIBOR index. For many first time home buyers or those who plan to move, they still have the option to leave the loan before the seven year fixed period ends with no prepayment penalty.
Disadvantages of adjustable rate mortgages
By now, we've already touched on the disadvantages of adjustable rate mortgages. Let's recap.
- Your rate can increase over time.
- Even with rate caps, this makes it harder to budget for your monthly mortgage payments.
Easy enough, right? Still, it can be difficult to decide whether or not you meet the criteria for an adjustable rate mortgage.
When an adjustable rate mortgage makes sense
Here are three reasons an adjustable rate mortgage loan may make sense.
1. You’re buying when mortgage rates are higher than normal.
If it’s likely that mortgage rates could fall in the next few years, an ARM may enable you to take advantage of that during the adjustment period.
2. You don’t plan to live in the home beyond the ARM term.
If your plans for the home you’re buying are short-term, it may make sense to use an ARM for financing. If you put the house on the market in five years, it won’t matter what your new interest rate will be.
Therefore, it makes sense to pay as little in interest as possible to create as much equity as possible for when you do sell. Even if you’re not certain you will move, many experts advise doctors just starting in a new practice to consider an ARM because of the possibility you may relocate in five to 10 years.
3. You can potentially pay down your principal faster.
One home financing strategy is to use an ARM to take advantage of the lower upfront interest rate to build home equity faster. First, determine the principal and interest payment you could afford on a 30-year fixed. (This applies to both standard mortgage and physician mortgage programs.) Then instead of getting the fixed-rate mortgage, finance your home with an ARM. This will which because of the lower interest rate will offer a lower monthly payment.
Pay the amount you would have been required each month on the 30-year fixed. The extra money you pay will reduce the principal balance faster than if you paid the minimum on the ARM.
Here’s an example. Say you’re looking at obtaining a zero-down physician’s mortgage for $400,000. You have the option of financing with a 30-year fixed at 5 percent, or a 5-year ARM at 4 percent.
The monthly principal and interest payment on the 30-year loan would be about $2,150. The required payment on the ARM would be $1,910.
If you made the higher payment ($2,150) on the ARM, you would be paying down an additional $240 in principal each month. At the end of the five-year adjustable rate period, that means your principal would be $14,400 less than if you made the minimum payment.
Or looking at it another way, after five years your mortgage balance would be:
- $367,314 on the 30-year fixed loan making a $2,150 monthly payment.
- $361,314 on the ARM making a $1,910 monthly payment.
- $347,389 on the ARM making a $2,150 monthly payment.
In this scenario, you would have $20,000 more in equity after five years using the ARM but making the higher payment amount of the 30-year fixed.
Unfortunately, there is no one-size-fits-all solution to home financing. Each type of mortgage loan has various pros and cons to offer, which is why it's important to understand:
- The advantages and disadvantages of fixed rate mortgages.
- The advantages and disadvantages of adjustable rate mortgages.
- When it makes sense to use each.
But your work doesn't stop there. When it comes time make your decision, it's crucial that you factor in your financial goals and long term plans.