Guide to Fixed-Rate Vs. Adjustable Rate Home Loans
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If you’re on the market for a home loan, you’ve probably been tossing around the idea of whether to get a fixed-rate or an adjustable-rate mortgage. Every home loan comes with its own set of pros and cons, and it's important to understand what they are before making any final decisions.
So wherever you find yourself in the home-buying process, here’s some food for thought in the debate of fixed-rate vs. adjustable-rate mortgages, plus all the details on picking the best type of mortgage loan for your needs. Let’s take a look at the two common types of mortgages.
In this article
What’s a fixed-rate mortgage?
A fixed-rate mortgage is pretty much what it sounds like — a mortgage with fixed interest rates. But this aptly named loan comes with quite a few details that are worth knowing. For one thing, fixed-interest rate mortgages maintain the same interest rate for the life of the loan. That means if you take out a 30-year mortgage, you can expect to pay the same rates for that entire time unless you choose to refinance.
People tend to like this kind of mortgage for its predictability. Although the amounts going towards your loan principal and interest may change every month, your overall monthly payments will remain the same, making it easier to set a budget.
Depending on what interest rates are when you sign for the loan, fixed rates can be a good thing or a bad thing. If interest rates are historically low, a fixed-rate mortgage will be more beneficial. Keep in mind that although interest rates may drop after you sign up for your mortgage, that won’t affect your loan's interest rates, which are locked in from the moment you sign.
Also of note is that although the interest rate is fixed, the amount of interest you pay will depend on the terms of your loan agreement. For example, while total monthly payments on a 30-year fixed mortgage may be low, you pay more interest by dragging the loan out over a 30-year loan term than if you were to pay it in 20 or even 15 years. Shorter-term mortgages will be more expensive monthly, but they can also save you quite a bit of interest.
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Who it’s best for
Fixed-rate mortgages are good for borrowers interested in having a mortgage with predictable monthly mortgage payments. If you want to be able to count on only paying a certain amount towards your loan every month (and avoid any surprises due to fluctuating interest rates), then a fixed-rate mortgage might work well for you.
Just remember that interest rates are only one piece of the puzzle, and you’ll also want to be sure to pick a loan with repayment terms that feel comfortable for your budget. If you have the cash flow and want to avoid paying extra in interest, you might opt for a shorter-term loan, say 15 or 20 years. But if you want low monthly payments over the long term, a standard 30-year mortgage would be best.
How to get a fixed-rate mortgage
To apply for a fixed-rate mortgage, you’ll first want to be sure your finances are in order. This means verifying things like your credit score, as well . Since these are all things lenders will look at when deciding whether or not to approve you for a loan, it helps to look at them yourself in advance.
Once you feel your finances are in a good place, it’s time to start shopping around for the best rates and mortgage terms, including your estimated closing costs. Be sure to compare offers from multiple lenders before settling on one — that way, you can get the most competitive loan package available.
What’s an adjustable-rate mortgage?
An adjustable-rate mortgage (ARM) is the opposite of a fixed-rate mortgage and offers borrowers the chance to get a loan with fluctuating interest rates. Unlike fixed-rate mortgages, the interest on your loan will change over the life of your loan agreement. However, your interest is likely to be lower at first than fixed-rate mortgages.
This fixed period of lower interest rates may last several months or even five years, but afterward, be prepared that your interest rates will increase. How much interest rates rise will depend on a grouping of interest rates called an index. Whenever this index increases, so will your interest payments. While your interest rate payments may decrease due to a falling index, that won’t necessarily be the case. Similarly, some ARMs may set a rate cap on how high or low your interest rates can go, but again, that’s not for sure. In other words — you should expect your rates to go up, not down.
Remember that many ARM rates also have something called a margin. This means that in addition to whatever the index is, you’ll be contractually obligated to pay several percentage points above it. Margins are typically small (usually around 2%) but can make a big difference on a large loan. They also add another layer of unpredictability to your monthly bill.
While ARMs will likely save you some money in the first months or years of your loan agreement, chances are the price will increase after the introductory period. This means that although your payments might be low to start, they will undoubtedly increase with new rate changes and rate adjustments after the initial rate period. While some people might enjoy the perks of lower payments upfront, others will find the unpredictability of increases a financial challenge. Since your payments can increase throughout the life of the loan, this may make it harder to stick to your budget.
Who it’s best for
ARMs are best for homebuyers looking for lower monthly payments upfront but who also feel comfortable with those payments increasing over a period of time. Be sure to review the details of your loan agreement to understand the adjustment frequency (ie. how often your interest rates will increase) and any caps on interest payments (high or low) that your lender sets. These will help you better plan your ARM payments despite the changing interest rates.
How to get an adjustable-rate mortgage
Getting an adjustable-rate mortgage is a lot like getting a fixed-rate mortgage in that the basic loan application process will be the same. Start by preparing your finances. This includes checking your credit score and preparing proof of income and any other documents stating your current assets and debts.
Once these things are in order, spend some time shopping around for the best mortgage before signing anything. This means contacting multiple lenders to find out what rates and loan packages they can offer and the terms of their loan agreements.
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What are the differences between fixed-rate and ARM?
The key difference between fixed-rate and adjustable-rate mortgages is how interest payments are calculated. While fixed-rate mortgages are locked into one interest rate throughout the life of the loan (whether it’s a 15-, 20-, or even 30-year mortgage), ARMs have fluctuating interest rates.
ARMs tend to have low interest rates to start, but borrowers should fully expect these rates to increase after the first several months or years, depending on the terms of the loan. ARMs can be a great way to save money upfront, but borrowers almost certainly end up paying that money back later on. These loans are also less predictable than fixed-rate loans, allowing borrowers to calculate and budget their monthly payments more easily.
Pros & cons of fixed-rate mortgages
Pros
- Set interest rates over the life of your loan, whether that’s 15, 20, or 30 years
- Reliable monthly payments
Cons
- Locked into whatever interest rates are set at the time of signing your loan, unless you consider refinancing the loan later for lower rates
- Higher interest rates than ARMs
Pros & cons of adjustable-rate mortgages
Pros
- Interest rates may be lower than fixed-rate mortgages for the first several months or years of the loan
- Initial lower rates can make your monthly payments more affordable
Cons
- Your rates will increase after the initial rate period ends, and may continue to fluctuate thereafter
- Budgeting can be made more difficult with varying interest rates
- Many ARMs also have margins, which add an extra few percent to the index of interest rates — meaning you’ll likely pay more than the going interest rate at any given time
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The bottom line
There’s a lot to consider when it comes to deciding which type of mortgage is right for you. Start by looking at your finances and deciding what you’d like your monthly payments to be. If you’re more in favor of lower payments to start, an ARM might work well for you. If, by contrast, you’d like predictable payments throughout the life of your loan, you might consider a fixed-rate mortgage.
Whatever you decide, be sure to shop around and talk to different lenders. This will help you understand what’s available and ensure you secure the most competitive rates.
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Writer
Larissa Runkle divides her time between a cabin in the San Juan Mountains and traveling in a converted van with her partner and pup. She writes for finance, real estate, and lifestyle publications, and is also at work on several fiction projects.
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