Choosing Between Fixed and Adjustable-Rate Mortgages: Pros and Cons

When buying a home, you have many decisions, including the type of financing to secure. Most borrowers can choose between a fixed and adjustable-rate mortgage, but they have vast differences.

Here’s everything you must know about choosing between the two loan types.

 

What is a Fixed Mortgage Rate?

As the name suggests, a fixed mortgage rate has one interest rate for the life of the loan. When you apply for the mortgage, you lock in the rate, and it remains the same until you pay it off or refinance it.

Fixed-rate mortgage loans usually have slightly higher interest rates than ARM rates initially because your rate remains unchanged no matter what happens in the market, whereas ARM rates change.

 

How Does it Work?

When you apply for a fixed mortgage rate, you apply for a loan with a 15 – 30-year term. The rate you’re assigned is what you’ll pay on the mortgage balance for the entire term. It doesn’t matter what happens in the economy or if market rates increase or decrease – your rate never changes.

Because your rate never changes, your mortgage payment doesn’t change, at least the principal and interest portion of the payment. You’ll pay the same amount on your first mortgage payment as you would for subsequent payments.

This means you pay the same rate throughout the life of the loan. The amount of your payment that covers interest will decrease as you slowly pay down your loan balance. As you near the end of your mortgage term, your payment amount (which is the same) covers more principal than interest because you’ve paid your balance down.

The only difference is if you include your real estate taxes and homeowner’s insurance in your mortgage payment (escrow), those amounts may change throughout the life of the loan. So, while your standard mortgage payment won’t change, the overall payment may change slightly if property taxes, or home insurance premiums increase (or decrease).

 

Benefits of a Fixed Mortgage Rate

As you can imagine, there are many benefits of a fixed mortgage rate, including:

  • Stable payment: If you don’t like worrying about your mortgage payment from one year to the next, a fixed-rate mortgage can be the answer. Your principal and interest payments don’t change. You’ll pay the same amount monthly until it’s paid in full. This can give borrowers incredible peace of mind and make budgeting much easier.
  • Predictable loan costs: Understanding how much a loan costs over its lifetime is important as it affects your finances long-term. Knowing how much interest you’ll pay for the loan is key to determining this number.
  • No risk of an increasing rate: No matter what happens in the economy, you don’t have to worry about interest rates increasing. For example, if inflation skyrockets and mortgage rates increase accordingly, you still pay your lower fixed rate if you keep the loan.

 

Downsides of a Fixed Mortgage Rate

Like any financial product, there are downsides of a fixed-rate mortgage you should understand.

  • Higher than ARM rates initially: ARM rates often have an attractive introductory rate much lower than fixed rates. For the first year, at least, you’ll likely pay a higher rate than you would with an ARM.
  • You must refinance to get a lower rate: If mortgage rates fall, you cannot get a lower rate unless you refinance, which takes time and costs money. It’s not always in your best interest to do this, so always look at the big picture and total costs.

 

What is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage, or ARM, is generally a 30-year mortgage with a rate that adjusts annually. Lenders can set up adjustable-rate mortgages in different ways, but the premise is the same – the rate changes as the market dictates, making the payment unpredictable.

 

How Does it Work?

Adjustable-rate mortgages have more moving pieces than fixed-rate mortgages. Rather than one rate throughout the term, you get a fixed rate for the introductory period, and then the rate adjusts according to certain factors.

The intro period can range from 2 – 7 years, depending on the lender and chosen terms. From there, the rate changes annually based on the following:

  • Index: This is the benchmark lenders use to base your ARM rate. Common indices used include the LIBOR or Prime rate.
  • Margin: This is the amount the lender will add to the index on each adjustment date. This number doesn’t change.

In addition to the above factors, lenders use the following to determine your adjusted rate:

  • Initial adjustment cap: This is the maximum amount the rate can change for the first adjustment after the introductory period.
  • Subsequent adjustment cap: This is the maximum amount the rate can change for each rate change.
  • Lifetime adjustment cap: This is the maximum amount the rate can change over the life of the loan.

 

Benefits of an Adjustable-Rate Mortgage

Adjustable-rate loans may seem confusing, but they have some benefits, including:

  • Lower intro rate: If you only plan to have your mortgage for a short period, the lower introductory rate can save you money versus a fixed-rate loan. Even if you keep it long-term, the first few years of lower payments can make your mortgage more affordable.
  • Chance for rates to decrease: No one can predict if rates will increase or decrease, so there’s always the chance your mortgage rate and payment will decrease.

 

Downsides of an Adjustable-Rate Mortgage

It’s always a good idea to understand the downsides of a mortgage. Here are the disadvantages of choosing an ARM.

  • Rates can increase: There’s a good chance interest rates will increase, making your payment go up. While you know the worst-case scenario for your rates, you can’t predict your rate or payment during any change.
  • Hard to budget: It can be hard to budget for your mortgage payment when you don’t know what it will be from year to year. This can cause financial issues if the payment gets unaffordable.

 

The Similarities Between Fixed and Adjustable-Rate Mortgage Loans

Despite their differences, there are some similarities between fixed and adjustable-rate mortgages.

  • You must qualify: Lenders must ensure you can afford the mortgage with its initial and any adjusting rates. You must prove you have a solid enough credit history and income to afford the mortgage, plus any existing debts.
  • The house is collateral: You must have a house that is the collateral for the mortgage, and it must be worth enough to create the loan-to-value ratio lenders require.
  • 30-year terms: ARMs and fixed-rate loans are available as 30-year terms; however, you can also get a shorter-term fixed-rate loan if desired.

 

How to Choose Between a Fixed and Adjustable-Rate Mortgage

Choosing between a fixed and adjustable-rate mortgage is a big decision. Here’s when to consider each one.

 

Fixed Rate Loan

Here are the situations when you may want to consider a fixed-rate loan:

  • You are in your ‘forever home.’ Having a predictable monthly payment can provide peace of mind because you always know how much your mortgage payment is.
  • Interest rates are currently low. If you can lock in a low interest rate, why take the chance on a rate that can adjust?
  • You have a fixed income. A changing mortgage payment can be unpredictable and unaffordable if you live on a fixed income. A fixed rate ensures you always know the amount of your payment.

 

Adjustable-Rate Loan

Sometimes, an adjustable-rate loan makes more sense. Here are the situations it may be better.

  • You need breathing room in your budget initially. Buying a new home is a big expense. If you have a lot of payment shock initially, you may consider an ARM to get the lower payment upfront and can decide how to proceed before it adjusts in the future.
  • Interest rates are currently high. Since ARMs have low introductory rates, you can save money during the first few years and decide if you should refinance before it adjusts or keep it.
  • The purchase is temporary. If you’re purchasing the home for a short period, you can borrow an ARM loan with an introductory period as long as you intend to be in the home.

 

Final Thoughts

Give careful thought to choosing between a fixed and adjustable-rate loan. They have tremendous differences and can greatly affect your loan’s monthly cost and affordability. Look at the big picture, including the loan’s total cost, how your monthly payment would be affected, and which is the most affordable today and down the road.