Fixed Versus Adjustable Mortgages: Find Out Which Is Best

When you get a mortgage, there are many loan features to consider. One of the key decisions is whether to go with a fixed- or adjustable-rate loan. Each has benefits and drawbacks, and your decision should be guided by your budget, housing needs and appetite for financial risk.

What is a fixed-rate mortgage?

A fixed-rate mortgage has the same interest rate for the life of the loan. In other words, your monthly payment of principal and interest won’t change. (Note your mortgage payments can fluctuate as your property taxes or homeowners insurance change over time, because those costs are usually wrapped into your loan payments in escrow.)

A fixed-rate mortgage is the most popular type of financing because it offers predictability and stability for your budget. Lenders typically charge a higher interest rate for a fixed-rate mortgage than they do for an ARM, which can limit how much house you can afford.

The most common type of mortgage today is the 30-year fixed. At an interest rate of 3 percent, a $300,000 30-year fixed loan will have monthly payments of around $1,265, not including insurance or taxes.

Pros of a fixed-rate mortgage

  • Rates and payments remain constant.
  • Stability makes budgeting easier. Homeowners can manage their money with more certainty because their housing payments don’t change.
  • It’s simple to understand, so it’s good for first-time buyers who might not know what a 7/1 ARM with 2/6 caps is, for example.

Cons of a fixed-rate mortgage

  • If interest rates fall, fixed-rate mortgage borrowers have to refinance to take advantage of that, plus pay borrowing fees and costs all over again.
  • It could cost more in interest over the life of the loan if you secure the loan at a higher rate and you don’t refinance if rates drop.
  • It is virtually identical from lender to lender and generally cannot be customized.

What is an adjustable-rate mortgage?

An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that can change periodically. This means that the monthly payments can go up or down throughout the life of the loan. Generally, the initial interest rate is lower than that of a comparable fixed-rate mortgage. After the fixed-rate period ends, the interest rate on an ARM loan moves based on the index it’s tied to.

The index is an interest rate set by market forces and published by a neutral party. There are many indexes, and your loan paperwork identifies which index a particular adjustable-rate mortgage follows. Interest rates are unpredictable, though they’ve been at historic lows since the start of the pandemic.

The most popular adjustable-rate mortgage is the 5/1 ARM. The 5/1 ARM’s introductory rate lasts for five years. (That’s the “5” in 5/1.) After that, the interest rate can change once a year. (That’s the “1” in 5/1.) Some lenders offer 3/1 ARMs, 7/1 ARMs and 10/1 ARMs.

At an interest rate of 2.85 percent, the monthly payment for the first five years on a $300,000 30-year 5/1 ARM would be around $1,240, not including taxes or insurance.

Pros of an adjustable-rate mortgage 

  • It has lower rates and payments early in the loan term. Because lenders can consider the lower payment when qualifying borrowers, people can buy more expensive homes than they otherwise could.
  • It allows borrowers to take advantage of falling rates without refinancing. Instead of having to pay a whole new set of closing costs and fees, ARM borrowers just sit back and watch the rates — and their monthly payments — fall.
  • It can help borrowers save and invest more money. Someone who has a payment that’s $100 less with an ARM can put that money in a higher-yielding investment.
  • It offers a cheaper way for borrowers who don’t plan on living in one place for very long to buy a house.

Cons of an adjustable-rate mortgage

  • Rates and payments can rise significantly over the life of the loan, which can be a shock to your budget.
  • Some annual caps don’t apply to the initial loan adjustment, making it difficult to swallow that first reset.
  • ARMs are more complex than their fixed-rate counterparts. Lenders have much more flexibility when determining margins, caps, adjustment indexes and other things, so it can be easy to get confused or locked into loan conditions you don’t understand.

Key differences between ARMs and fixed-rate mortgages

The main difference between an ARM and a fixed-rate mortgage is the interest rate. An ARM typically has a lower initial interest rate than a fixed-rate loan. That means the monthly payment during the introductory period of an ARM is lower than the payment of a fixed-rate mortgage.

After the ARM’s initial rate period, however, the rate and monthly payment can rise. Although there’s a limit to how much your rate can increase, it can still climb considerably, and you could wind up with an unaffordable monthly payment after the first few years of your loan term.

A fixed-rate mortgage, by contrast, has a fixed payment throughout the life of the loan, and the rate and payment won’t change unless you refinance to a different loan.

One other point of differentiation: ARMs generally require a slightly higher down payment of 5 percent. For a fixed-rate conventional loan, you can put down just 3 percent.

ARM vs. fixed: Example mortgage payments

5/1 ARM 30-year FRM
Mortgage amount $300,000 $300,000
Interest rate 2.85% 3.00%
Monthly payment $1,241 for first 5 years, then adjusts based on new rate $1,265 for 30 years

ARM vs. fixed: Which should I choose?

Now that you know about the differences between an ARM and a fixed-rate mortgage, you’re better able to figure out which option works best for your situation. Here are important questions to ask when deciding which loan is right for you.

1. How long do you plan on staying in the home?

If you’re going to be living in the house for only a few years, it can make sense to take the lower-rate ARM, especially if you can get a reasonably priced 3/1 or 5/1. Your payment and rate will be lower, and you can build savings for a bigger home down the road. Plus, you’ll never be exposed to huge rate or payment adjustments because you’ll be moving before the adjustable-rate period begins.

2. How frequently does the ARM adjust, and when is the adjustment made?

After the initial fixed period, most ARMs adjust every year on the anniversary of the mortgage. The new rate is actually determined by the index value about 45 days before the anniversary, based on the specified index, but some adjust as frequently as every month. If that’s too much volatility for you, go with a fixed-rate mortgage.

3. What’s the interest rate environment like?

When rates are relatively high, ARMs make sense because their lower initial rates allow borrowers to still reap the benefits of homeownership. When rates are falling, borrowers have a decent chance of getting lower payments even if they don’t refinance. When rates are relatively low, however, fixed-rate mortgages make more sense. Since the start of the pandemic, interest rates on all kinds of mortgages have been historically low, and the gap between fixed rates and ARM rates has narrowed significantly.

4. Could you still afford your monthly payment if interest rates rise significantly?

ARM payments vary considerably and can change significantly from year to year as market conditions shift. On a $150,000 one-year adjustable-rate mortgage with 2/6 caps, your 5.75 percent ARM could rise to 11.75 percent, with the monthly payment shooting up as well. Experts say that when fixed mortgage rates are low, fixed mortgages tend to be a better deal than an ARM, even if you plan to stay in the house for only a few years.

Summary: What’s the difference between a fixed and adjustable-rate mortgage?

Bottom line

Adjustable-rate mortgages and fixed-rate mortgages are two ways to finance a home purchase. ARMs usually have lower initial payments, but those can rise after the initial rate period. This makes them ideal for people who plan to move or refinance their loan after a few years. Fixed-rate loans are typically more expensive upfront, but are more predictable in that your payments don’t change. This makes them better for people who plan to stay in their new home for the long term, need stability in their budget or both.

Learn more:

Source link

Leave a Reply

Your email address will not be published. Required fields are marked *