The Difference Between a Fixed-Rate and an Adjustable-Rate Mortgage
As their names suggest, a fixed-rate mortgage charges the same interest rate throughout the life of the loan, while an adjustable-rate mortgage (ARM) has an interest rate that changes periodically over the loan term. What does this mean? Basically, with a fixed-rate mortgage, your monthly payment stays the same for as long as you have the loan. Conversely, if you take out an ARM, your monthly payments remain the same for a certain period of time, with the most common being up to 10 years, then the rates can go up or down, based on the prime rate and specific indexes, such as the Cost of Funds Index and Treasury securities.
Understanding the Basics of Fixed-Rate and Adjustable-Rate Mortgages
To help you decide whether you should get a fixed-rate mortgage or an ARM, here are the most important differences and similarities between these two types of mortgages.
- Mortgage payment fluctuations – In general, ARMs have an initial interest rate and payment amount, which remain in effect for a limited period of time. After that period, the monthly payment amount can change significantly every month, quarter, or year, based on the variable interest rate. With some ARMs, the interest rate and monthly payment can change every 3 or 5 years. The period of time between interest rate changes is known as the adjustment period. Coming down to fixed-rate mortgages, one important consideration is that the monthly mortgage payment can also change, even though the interest rate stays the same over the duration of the loan. That’s because the overall monthly payment depends not only on the interest rate but also on the homeowners' insurance and property taxes, which could fluctuate from one year to another.
Pros: ARMs allow borrowers to take advantage of lower interest rates without refinancing, thus without having to pay the closing costs and fees associated with a mortgage refinance. On the downside, the monthly payment of an ARM could also rise significantly over the loan term. Conversely, the monthly payment of a fixed-rate mortgage remains relatively constant, even though it could rise slightly due to an insurance or tax increase.
- Interest rate – Some ARMs may have a lower interest rate than fixed-rate mortgages for a set period of time. This rate is commonly called the introductory rate. Once the initial period ends, the ARM is converted to the indexed interest rate stipulated in the mortgage agreement. Most lenders also allow borrowers to refinance their ARMs into fixed-rate mortgages after the introductory period. Unlike the introductory rate of ARMs, the interest rate of fixed-rate mortgages tends to be higher. Many lenders offer a slightly higher interest rate for a fixed-rate mortgage because they take into account the anticipated interest rate changes.
Pros: While the lower introductory rate of an ARM may allow you to qualify for a bigger mortgage, which means that you may be able to buy a more expensive home than you otherwise could afford, the predictable payments of a fixed-rate mortgage make it easier to plan your budget and pay off debt.
- Rate Caps: To prevent significant increases in the interest rates of ARMs, these types of loans come along with specific rate caps, such as: an initial cap, which limits the amount the interest rate can increase or decrease after the introductory rate; a periodic cap, which puts a limit on the maximum amount that the interest rate can increase from one adjustment period to another; and a lifetime cap, which limits the total amount the interest rate can increase over the loan term.
On the other hand, the national average interest rate for fixed-rate mortgages is established based on mortgage bonds or mortgage-backed securities along with a target interest rate maintained by the Fed. However, a borrower can rarely lock in the national average mortgage rate. While this rate can act as an indicator for the overall interest rate for fixed-rate mortgages, lenders determine interest rates based on the credit scores, income, DTI ratios, and LTV ratios of applicants in conjunction with inflation, economic growth, and the state of the bond and housing markets.
Pros: Even with rate caps, the monthly payment on an ARM can increase substantially over time as market conditions shift. It is for this reason most financial experts consider fixed-rate mortgages a better deal, particularly when the national average interest rate is low.
Both fixed-rate and adjustable-rate mortgages have their own advantages and disadvantages. The decision to opt for a fixed-rate or an ARM, therefore, shouldn’t be based solely on their pros and cons but also on other factors, including the interest rate environment, the rate you can obtain for each type of loan, and how long you plan to stay in the home. Whether you’re considering a fixed-rate mortgage or an ARM, please get in touch with our experienced mortgage brokers today to find out which type of mortgage is right for you!
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