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Understanding Fixed-Rate and Adjustable-Rate Mortgages

When you’re shopping for a mortgage loan, one of your first major decisions is what type of interest rate to get. Your options fall into two categories—fixed-rate mortgages and adjustable-rate mortgages (ARMs)—which differ in how interest is charged. A fixed-rate mortgage has interest that remains the same for the life of the loan, while an ARM’s interest fluctuates over time.

Understanding how each type of interest works and their benefits and downsides can help you determine which is best for your unique situation.

What Is a Fixed-Rate Mortgage?

A fixed-rate mortgage comes with a set interest rate for the entire duration of the loan (typically 15 or 30 years). The beauty of a fixed-rate home loan is that its locked interest rate guarantees your payments will remain the same as long as you have the mortgage. Not surprisingly, this type of mortgage is the most popular type of home loan with homeowners who prefer a predictable payment that is easy to budget for.

Advantages of a Fixed-Rate Mortgage

One of the most significant benefits of a fixed-rate mortgage is its predictability. From the moment you sign for your loan, you know exactly what your interest rate and monthly mortgage payment will be. A fixed-rate option provides your home loan with reliability you won’t find with an ARM, where rates can go up after the introductory period.

A steady interest rate simplifies your budget and provides unique benefits you may not find with an ARM. For example, you can easily anticipate your annual mortgage interest deductions on your tax return ahead of time. Additionally, it may be easier to strategize for an earlier mortgage payoff. For instance, you can calculate the amount you’ll spend over the life of the loan—including interest charges—and then assess your potential savings by paying off the loan ahead of schedule.

Comparing fixed-rate mortgages is simpler than comparing ARMs since you only have to evaluate rates and closing costs. However, with an ARM, you need to compare not only closing costs but also other factors like the initial rate, the length of the introductory period, and potential rate changes during the term.

Disadvantages of a Fixed-Rate Mortgage

Perhaps the biggest disadvantage of fixed-rate mortgages is that they typically have higher interest rates than adjustable-rate loans, particularly in the initial years of the loan. As a result, you could pay more interest and have a larger monthly payment if you only live in the house for a few years.

With higher monthly payments in the initial years of the term, your lender may have more stringent requirements to ensure you can cover the larger payments. If your credit needs improvement, an ARM may offer a more lenient approval process.

Locking in a fixed rate when interest rates are low is a financially savvy move. Conversely, locking in a rate when interest rates are high can be very costly. While you might save money by refinancing to a lower rate later on, the associated costs can be substantial. Refinancing may be worth it to save tens of thousands of dollars during the loan term, but it’s still a major expense.

What Is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage is a home loan that offers a low initial interest rate—usually lower than those for fixed-rate mortgages—for the first few years. Once this introductory period ends, the interest rate shifts to a “floating” rate that can change with market conditions.

ARMs vary by lender and loan, but when interest rates adjust, it’s typically upward. It’s critical to read your loan agreement carefully before signing to make sure you understand all the specifics. These are variables to bear in mind when comparing adjustable-rate mortgages:

• Introductory period: Introductory periods vary, but five-year introductory periods on 30-year loans are the most common. You may also find one-, three-, and seven-year introductory periods.
• Index rate: The floating rate is tied to an underlying index to set the ARM rate. Indexes commonly used include the yield on one-year constant-maturity Treasury (CMT) securities and the U.S. prime rate.
• Margin: The margin is the amount added to the index to determine the rate you pay. This is a fixed percentage specified in your loan agreement. So, if your margin is 2% and the index rate is 5%, your adjustable mortgage rate would be 7%.
• Rate adjustment frequency: Once the introductory period ends, the rate on an ARM resets at regular intervals. Once a year is common, but two- and three-year periods may also be used, and some ARMs reset every six months. On the reset date, a new rate is calculated by adding the margin to the value of the index on that day; the new rate applies until the next reset date.
• Rate caps: To prevent extreme increases in ARM rates, ARMs typically limit the amount their interest rates can increase. A periodic cap limits the amount the rate can increase from one adjustment period to the next, while a lifetime cap limits the total amount the rate can ever increase over the introductory rate. Some ARM loan agreements also specify payment caps—limits on the amount your monthly payment can rise each readjustment period.

It’s wise to consider both the advantages and disadvantages of adjustable-rate mortgages before applying for one.

Advantages of an Adjustable-Rate Mortgage

The biggest draw of an adjustable-rate mortgage is its low introductory interest rates, which are usually lower than fixed-rate mortgage rates. The accompanying lower payments may help lower-income borrowers afford a new home. This option may make sense if you’re early in your career and expect to earn more in the future—enough to reasonably cover the higher ARM payments that kick in once the introductory period expires.

Low ARM introductory rates are also attractive to borrowers who don’t plan to keep their properties for more than a few years. Selling a home before an ARM’s introductory rate expires is a common tactic, and many ARM loan agreements discourage it by including stiff prepayment penalties. Of course, this strategy can also backfire if the local real estate market stalls or takes a downturn, making it difficult to sell the property.

While ARMs are riskier loans than fixed-rate mortgages, they typically offer an easier qualification process for those with less-than-ideal credit. ARMs are the most common type of subprime mortgage due to their initial affordability and accessibility, but you must be aware of the increased rate and higher monthly payments down the line.

Disadvantages of an Adjustable-Rate Mortgage

The biggest disadvantage of adjustable-rate mortgages is their unpredictable nature, which can be hard to budget for. Although ARMs typically have rate and payment caps, anticipating how much your costs will rise can be challenging and stressful.

If you stay in your home long enough, an ARM may cost you more in interest and monthly payments than a fixed-rate loan. In climates where interest rates are increasing steadily, an ARM with a payment cap can put you in a situation known as negative amortization. In this case, even though you continue to make full payments, you could actually owe more money each month.

The minimum down payment on a conventional ARM is usually 5%, two points higher than the 3% baseline down payment on a conventional fixed-rate loan.

Fixed-Rate Mortgage vs. ARM Example

The introductory period of an ARM may feature a lower interest rate and payment than a fixed-rate mortgage, saving you money early on. But to effectively compare these two mortgage types, it’s essential to understand the maximum costs you could incur in either case.

To illustrate and compare each scenario, here’s a cost comparison on a $400,000 mortgage with a 2/1/5 cap schedule and the same amount in a fixed-rate mortgage. This 5/1 ARM comes with a maximum initial adjustment of 2% after five years, with subsequent annual 1% maximum increases up to a 5% lifetime adjustment cap. The ARM example assumes the rates increased by the maximum allowed.

Note: Estimates are for illustration purposes and are not a guarantee of rates and terms you may receive. For simplicity, the chart excludes costs for private mortgage insurance (PMI), taxes, HOA fees, and more.

In this scenario, an ARM would cost you over $200,000 more than a fixed-rate mortgage if you held the home loan for the full 30-year term. However, if you sold your home during its introductory period or you refinanced to a fixed-rate mortgage, your overall expense may be less with an ARM.

Is It Better to Have a Fixed-Rate or Adjustable-Rate Mortgage?

Fixed-rate and adjustable-rate mortgages each have their own pros and cons, so deciding which is best for you may depend on your financial situation.

A fixed-rate mortgage may be best if:

• Interest rates are low. In a low-interest-rate environment, locking in a low rate can keep your payments lower over the term of your loan when rates eventually climb.
• You plan on staying in your home for the long haul. Fixed interest rates and payments make it easy to budget for your payment.
• You value lower overall costs. ARMs may be less expensive initially, but once your introductory period ends, rates can fluctuate up or down in response to market conditions. In most cases, interest rates rise when they adjust, leading to higher overall interest costs.

While fixed-rate mortgages are a popular and generally safer choice for borrowers, there are situations where an ARM could benefit you, such as if:

• You only plan to live in the home for a few years. If you’re confident you’ll relocate before the fixed-rate period ends, an ARM could save you money. You’ll benefit from the initial lower rate and payment, allowing you to move before the rate increase. Keep in mind, however, that market conditions change, and if home prices fall, you could end up upside-down on the loan.
• Interest rates are high. Since the introductory rate on an ARM is usually lower than on fixed-rate loans, it may help you afford a new home. If you plan on moving or refinancing during the fixed-rate period, you can benefit from lower payments initially. Alternatively, if you expect your income to rise soon, you might find it easier to manage the higher payments sure to come when your loan begins adjusting.

Check Your Credit Score Before Applying

Carefully consider the benefits and downsides of fixed-rate and adjustable-rate mortgages to help determine which might benefit you the most. In either case, you must meet your lender’s income and credit requirements to qualify. You’ll typically need a good credit score of at least 620 to qualify for a mortgage, but some loan programs may allow for a lower score.

Generally, the higher your credit score, the higher your odds of loan approval and securing a lower interest rate. Before applying for a fixed-rate or ARM mortgage, consider checking your Experian credit report and credit score to see where you stand. Take steps to improve your credit if necessary to strengthen your position.

For any mortgage-related needs, feel free to call O1ne Mortgage at 213-732-3074. Our team is ready to assist you with confidence and expertise.

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