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Mortgages: Fixed Rate Versus Adjustable Rate
Choosing the right mortgage can help homebuyers avoid costly mistakes.Fixed-rate loans charge a set rate of interest that does not change over time. The balance of principal and interest paid each month varies, but the overall payments remain the same, which helps homeowners budget. Borrowers are protected from interest rate increases, but when rates are high, it’s more difficult to qualify for a loan because payments are less affordable.Adjustable-rate loans feature interest rates that vary over time. The initial rate is below the market rate, and then it rises. ARMs typically maintain the initial rate for anywhere from a month to 10 years. But if held long enough, the ARM will eventually surpass the going rate for fixed-rate loans.ARMs offer low initial payments. They let the borrower qualify for a larger loan, and they let the borrower enjoy lower interest rates in a falling rate environment.To choose the right one for you, consider these questions:How large of a mortgage payment can you afford today?Could you still afford an ARM if interest rates rise?How long do you intend to live on the property?Are interest rates heading up or down, and do you expect that trend to continue?An ARM may be right for you if low payments in the short term are important, and you don’t plan to live on the property for long. If interest rates are expected to fall, an ARM ensures you will enjoy lower rates without having to refinance. But if you want a predictable payment, or interest rates are climbing, a fixed loan is better.
Reviewed by Pamela RodriguezReviewed by Pamela Rodriguez
Fixed-Rate vs. Adjustable-Rate Mortgages
Fixed-rate mortgages and adjustable-rate mortgages (ARMs) are the two types of mortgages that have different interest rate structures. Fixed-rate mortgages have an interest rate that remains the same throughout the term of the mortgages, while ARMS have interest rates that can change based on broader market trends. Learn more about how fixed-rate mortgages compare to adjustable-rate mortgages, including the pros and cons of each.
Key Takeaways
- A fixed-rate mortgage has an interest rate that does not change throughout the loan’s term.
- Interest rates on adjustable-rate mortgages (ARMs) can increase or decrease in tandem with broader interest rate trends.
- The initial interest rate on an ARM is usually below the interest rate on a comparable fixed-rate loan.
- ARMs are typically more complicated than fixed-rate mortgages.
Investopedia / Sabrina Jiang
Fixed-Rate Mortgages
A fixed-rate mortgage has an interest rate that remains unchanged throughout the loan’s term. So, your payments will remain the same each month. (However, the proportion of the principal and interest will change). The fact that payments remain the same provides predictability, which makes budgeting easier.
The main advantage of a fixed-rate loan is that the borrower is protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise. Fixed-rate mortgages are also easy to understand.
A potential downside to fixed-rate mortgages is that when interest rates are high, qualifying for a loan can be more difficult because the payments are typically higher than for a comparable ARM.
Warning
If broader interest rates decline, the interest rate on a fixed-rate mortgage will not decline. If you want to take advantage of lower interest rates, you would have to refinance your mortgage, which will entail closing costs.
How Fixed-Rate Mortgages Work
The partial amortization schedule below shows how you pay the same monthly payment with a fixed-rate mortgage, but the amount that goes toward your principal and interest payment can change. In this example, the mortgage term is 30 years, the principal is $100,000, and the interest rate is 6%.
| Payment | Principal | Interest | Principal Balance |
| 1. $599.55 | $99.55 | $500.00 | $99,900.45 |
| 2. $599.55 | $100.05 | $499.50 | $99,800.40 |
| 3. $599.55 | $100.55 | $499.00 | $99,699.85 |
A mortgage calculator can show you the impact of different rates and terms on your monthly payment.
Even with a fixed interest rate, the total amount of interest you’ll pay also depends on the mortgage term. Traditional lenders offer fixed-rate mortgages for a variety of terms, the most common of which are 30, 20, and 15 years.
The 30-year mortgage, which offers the lowest monthly payment, is often a popular choice. However, the longer your mortgage term, the more you will pay in overall interest.
The monthly payments for shorter-term mortgages are higher so that the principal is repaid in a shorter time frame. Shorter-term mortgages offer a lower interest rate, which allows for a larger amount of principal repaid with each mortgage payment. So, shorter term mortgages usually cost significantly less in interest.
Adjustable-Rate Mortgages
The interest rate for an adjustable-rate mortgage is variable. The initial interest rate on an ARM is lower than interest rate on a comparable fixed-rate loan. Then the rate can either increase or decrease, depending on broader interest rate trends. After many years, the interest rate on an ARM may surpass the rate for a comparable fixed-rate loan.
ARMs have a fixed period of time during which the initial interest rate remains constant. After that, the interest rate adjusts at specific regular intervals. The period after which the interest rate can change can vary significantly—from about one month to 10 years. Shorter adjustment periods generally carry lower initial interest rates.
Note
After the initial term, an ARM loan interest rate can adjust, meaning there is a new interest rate based on current market rates. This is the rate until the next adjustment, which may be the following year.
How ARMs Work: Key Terms
ARMs are more complicated than fixed-rate loans, so understanding the pros and cons requires an understanding of some basic terminology. Here are some concepts you should know before deciding whether to get a fixed vs. adjustable-rate mortgage:
- Adjustment frequency: This refers to the amount of time between interest-rate adjustments (e.g. monthly, yearly, etc.).
- Adjustment indexes: Interest-rate adjustments are tied to a benchmark. Sometimes this is the interest rate on a type of asset, such as certificates of deposit or Treasury bills. It could also be a specific index, such as the Secured Overnight Financing Rate (SOFR), the Cost of Funds Index or the London Interbank Offered Rate (LIBOR).
- Margin: When you sign your loan, you agree to pay a rate that is a certain percentage higher than the adjustment index. For example, your adjustable rate may be the rate of the 1-year T-bill plus 2%. That extra 2% is called the margin.
- Caps: This refers to the limit on the amount the interest rate can increase each adjustment period. Some ARMs also offer caps on the total monthly payment. These loans, also known as negative amortization loans, keep payments low; however, these payments may cover only a portion of the interest due. Unpaid interest becomes part of the principal. After years of paying the mortgage, your principal owed may be greater than the amount you initially borrowed.
- Ceiling: This is the maximum amount that the adjustable interest rate can be during the loan’s term.
Pros and Cons of ARMs
A major advantage of an ARM is that it generally has cheaper monthly payments compared to a fixed-rate mortgage, at least initially. Lower initial payments can help you more easily qualify for a loan.
Important
When interest rates are falling, the interest rate on an ARM mortgage will decline without the need for you to refinance the mortgage.
A borrower who chooses an ARM could potentially save several hundred dollars a month for the initial term. Then, the interest rate may increase or decrease based on market rates. If interest rates decline, you will save more money. But if they rise, your costs will increase.
ARMs, however, have some downsides to consider. With an ARM, your monthly payment may change frequently over the life of the loan, and you cannot predict whether they will rise or decline, or by how much. This can make it more difficult to budget mortgage payments in a long-term financial plan.
And if you are on a tight budget, you could face financial struggles if interest rates rise. Some ARMs are structured so that interest rates can nearly double in just a few years. If you cannot afford your payments, you could lose your home to foreclosure.
Indeed, adjustable-rate mortgages went out of favor with many financial planners after the subprime mortgage meltdown of 2008, which ushered in an era of foreclosures and short sales. Borrowers faced sticker shock when their ARMs adjusted, and their payments skyrocketed. Since then, government regulations and legislation have increased the oversight of ARMs.
Is a Fixed-Rate Mortgage or ARM Right for You?
When choosing a mortgage, you need to consider several factors, including your personal financial situation and broader economic conditions. Ask yourself the following questions:
- What amount of a mortgage payment can you afford today?
- Could you still afford an ARM if interest rates rise?
- How long do you intend to live in the property?
- What do you anticipate for future interest rate trends?
If you are considering an ARM, calculate the payments for different scenarios to ensure you can still afford them up to the maximum cap.
Note
If interest rates are high and expected to fall, an ARM will help you take advantage of the drop, as you’re not locked into a particular rate. If interest rates are climbing or a predictable payment is important to you, a fixed-rate mortgage may be the best option for you.
When ARMs Offer Advantages
An ARM may be a better option in several scenarios. First, if you intend to live in the home only a short period of time, you may want to take advantage of the lower initial interest rates ARMs provide.
The initial period of an ARM where the interest rate remains the same typically ranges from one year to seven years. An ARM may make good financial sense if you only plan to live in your house for that amount of time or plan to pay off your mortgage early, before interest rates can rise.
An ARM may also make sense if you expect to make more income in the future. If an ARM adjusts to a higher interest rate, a higher income could help you afford the higher monthly payments. Keep in mind that if you cannot afford your payments, you risk losing your home to foreclosure.
What Is a 5/5 Arm?
A 5/5 ARM is a mortgage with an adjustable rate that adjusts every 5 years. During the initial period of 5 years, the interest rate will remain the same. Then it can increase or decrease depending on market conditions. After that, it will remain the same for another 5 years and then adjust again, and so on until the end of the mortgage term.
What Is a Hybrid ARM?
A hybrid ARM is an adjustable rate mortgage that remains fixed for an initial period and then adjusts regularly thereafter. For example, a hybrid ARM may remain fixed for the first 5 years, and then adjust every year after that.
What Is an Interest-Only Mortgage?
An interest-only mortgage is when you pay only the interest as your monthly payments for several years. These loans generally provide lower monthly payment amounts.
The Bottom Line
Regardless of the loan type you select, choosing carefully will help you avoid costly mistakes. Weight the pros and cons of a fixed vs. adjustable-rate mortgage, including their initial monthly payment amounts and their long-term interest. Consider consulting with a professional financial advisor to review the mortgage options for your specific situation.
Read the original article on Investopedia.