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.
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.
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%.
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.
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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.
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.
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 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.
