Finding The Best Mortgage: Your Guide to Fixed-rate Vs. Adjustable Rate Home Loans
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 a 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 home loan for your needs.
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 actually comes with quite a few details that are worth knowing. For one thing, fixed-interest rates 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 the interest rates of your loan 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 actually depend on the terms of your loan agreement. For example, while total monthly payments on a 30-year fixed mortgage may be low, you actually pay more interest by dragging the loan out over a period of 30 year loan term than if you were to pay it in 20 or even 15 years. Shorter-term mortgages will be more expensive month to month, but they can also save you quite a bit of money in interest.
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 debt-to-income ratio. 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 — which will include things like your estimated closing costs. Be sure to compare offers from multiple lenders before settling on one — that way, you can be sure to get the most competitive loan package available.
What’s an adjustable rate mortgage?
An adjustable-rate mortgage (ARM) is basically 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 5 years, but afterwards 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 it’s possible that your interest rate payments decrease as a result of a falling index, that’s 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.
Keep in mind as well that many ARM rates have soething called a margin. This means that in addition to whatever the index is, you’ll be contractually obligated to pay several percent 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 or 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 up front, others will find the unpredictability of increases to be 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 those looking for lower monthly payments up front, but who also feel comfortable with those payments increasing over time. Be sure to review the details of your loan agreement to understand the adjustment frequency (ie. how often your interest rates will increase) as well as any caps on interest payments (high or low) that your lender sets. These will help you to better plan for 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 things like checking your credit score, and preparing your proof of income and any other documents stating your current assets and debts.
Once these things are in order, be sure to 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, as well as the terms of their loan agreements.
What are differences between fixed-rate and ARM?
The key difference between fixed rate and adjustable rate mortgages is in how interest payments are calculated. While fixed-rate mortgages are locked into one interest rate throughout the life of the loan (whether it’s 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 up front, but borrowers almost certainly end up paying that money back later on. These loans are also less predictable than fixed-rate loans which allow borrowers to calculate and budget their monthly payments more easily.
Pros & cons of fixed-rate mortgages
- Set interest rates over the life of your loan, whether that’s 15, 20, or 30 years
- Reliable monthly payments
- 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
- 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
- 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
The bottom line
There’s a lot to consider when it comes to deciding which type of mortgage is right for you. Start by taking a look 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 spend some time shopping around and talking to different lenders. This will help you get an idea of what’s available and also ensure you secure the most competitive rates.