If you’re buying a home soon, you’ll need to consider mortgage loans before you start shopping. There are two options to choose from fixed and adjustable-rate mortgages. In this guide, you’ll discover the benefits and drawbacks of each and how to decide which is best for you.
What is a Fixed Rate Mortgage?
As the name suggests, fixed-rate mortgages have the same interest rates for the life of the loan. This means your principal and interest payments won’t change. As a result, homeowners most commonly use this type of mortgage loan since it offers a predictable monthly payment that’s easier to work into your monthly spending plan.
Pros of Fixed Rate Mortgage Loans
- Consistent monthly payment for principal and interest
- Available for a 30- or 15-year term
Cons of Fixed Rate Mortgage Loans
- Borrowers must refinance to secure a lower rate if market conditions change
- You’ll pay closing costs each time you refinance your mortgage
What is an Adjustable Rate Mortgage?
Adjustable-rate mortgages (ARMs) come with fluctuating interest rates. In most cases, you’ll start off with a lower interest rate than a fixed-rate mortgage, but only for a set period, known as the introductory period. Once this window ends, you’ll get an interest rate that adjusts with market conditions or is based on the index to which it’s connected.
How ARMs Work
To illustrate how ARMs work, assume you get a 7/1 ARM. The introductory period will remain intact for seven years and could change annually after this time for the duration of the loan term. Below are some terms commonly used by lenders when discussing ARMs:
- Adjustment Frequency: the frequency by which the interest rate can change on an ARM, which can be monthly, quarterly or annually. Some ARMs adjust every three or five years.
- Margin: this percentage helps determine your interest rate. So, if your margin is 3% and the index rate is 0.25%, your interest rate is 3.25%.
- Interest Rate Cap: the amount by which your interest rate can increase during each adjustment period and over the loan term.
- Payment Caps: limits the total amount you can owe on your mortgage, which is typically 125% of the original loan amount
Pros of Adjustable Rate Mortgage Loans
- More affordable during the introductory period
- Refinancing is not required to secure lower interest rates if market conditions change
- It could be more cost-efficient for homeowners who only plan to stay in the home for a short period
Cons of Adjustable Rate Mortgage Loans
- Monthly mortgage payments (principal and interest) could be costly once the introductory interest period ends
- Homeowners who stay in the home for several years could spend a mini-fortune on interest
ARM vs. Fixed Rate: How to Choose
Here are some important considerations when deciding whether an ARM or fixed-rate mortgage is ideal for your situation.
Current Interest Rate Environment
What’s the average interest rate on mortgage products? Is it trending upward or downward?
How Long Do You Plan on Keeping the Home?
Do you plan to sell your home in a few years or stay put for some time?
How Frequently Will the ARM Adjust?
Will the interest rate on the ARM you’re considering change frequently? If so, how often?
ARM Payment Affordability at Higher Rates
Can you afford fluctuations in the monthly mortgage payment as the interest rate changes?
When To Choose a Fixed Rate Mortgage
A fixed-rate mortgage could be sensible if:
- You plan to live in the home for a long time and prefer consistent mortgage payments.
- You don’t want a mortgage with an interest rate that can change over time.
- The average mortgage interest rates are low as a result of market conditions.
When To Choose an Adjustable Rate Mortgage
In some instances, it could be more logical to take out an adjustable-rate mortgage:
- You’re only planning to stay in the home for a few years and want to take advantage of a lower interest rate and more affordable mortgage payments.
- Due to market conditions, the average interest rates on mortgage products are on the higher end.
- If interest rates increase, you have wiggle room in your budget to afford higher monthly payments.
