Fixed-rate mortgage vs. adjustable-rate mortgage

There are many mortgage types, but the two main ones are fixed-rate mortgages and adjustable-rate mortgages (ARMs). Each mortgage type has its advantages and disadvantages, so here’s an overview to help you decide if either is right for you.

What is a fixed-rate mortgage?

A fixed-rate mortgage loan locks in an interest rate for the life of your mortgage. This means your monthly payment of principal and interest will remain fixed. It also has a variety of term options, typically 15 or 30 years, but other term lengths, like 10 or 20 years, may be available as well.

Fixed-rate mortgage pros and cons

Fixed-rate mortgage pros

• This loan type helps protect the borrower from increases in monthly mortgage payments if interest rates rise.
• It has predictable payments that may allow for easier budgeting, especially if you plan to stay in your home for a long time.
• Takes market rates out of the equation, making it generally simpler to understand and may be good for first-time buyers or those who don’t want to spend time tracking interest rates.
• Locking in a fixed-rate mortgage when interest rates are low may save you a lot of money in the long run.

Fixed-rate mortgage cons

• You may pay more interest over the life of the loan, particularly if market interest rates fall more than they rise.
• To benefit from lower interest rates, you need to refinance, which has involves additional costs.
• Qualification depends on factors such as credit score and debt-to-income ratio; a high debt-to-income ratio can make qualifying more difficult for any mortgage type.
• Initial interest rates and monthly payments are typically higher than those of an ARM.

Considerations with a fixed-rate mortgage

• The future — do you plan to spend the next 15-30 years in your home to capture the benefit from a fixed-rate mortgage?
• Budget — do you want consistent and easy-to-track monthly payments?
• Interest rates —are current mortgage rates historically low for this loan type?

If you answered “Yes” to these questions, a fixed-rate mortgage might be the option for you.

What is an adjustable-rate mortgage? (ARM)

The key difference for an adjustable-rate mortgage is that the interest rate will change over time. With that said, an ARM typically has a fixed-interest rate for five-, seven- or 10-year terms before the rate begins to adjust. They also generally have a cap on interest rates, so they only increase to a certain point.

Adjustable-rate mortgage pros and cons

ARM pros

• The initial interest rate may be lower than what a fixed-rate mortgage may offer.
• If you have a larger loan, a lower initial rate may give you the opportunity for savings at the start.
• The initial fixed-rate period provides short-term payment stability, which can be helpful if you don’t plan to stay in the home long.
• If the market rates remain favorable, you may pay less interest over the life of the loan.
• ARMs can offer more flexibility in loan structure, allowing borrowers to customize the initial fixed-rate period and adjustment terms to better fit your financial plans, unlike fixed-rate mortgages which have a fixed interest rate for the entire term.

ARM cons

• Your financial outcome is dependent on the market, which may require you to pay more interest in the long term.
• The interest rate on your loan may significantly increase at an inconvenient time for you. If you aren’t able to keep up, this could lead to foreclosure.
• The loan is generally more complex to manage than a fixed-rate mortgage.
• As the loan payment can fluctuate, you may have more difficulty budgeting for monthly payments.

Concepts to know

Given the complexity of ARMs, there are a few extra variables to consider that don’t apply to fixed-rate mortgages. It may be helpful to have a grasp on these terms when asking your mortgage lender questions about a potential ARM agreement:

• Adjustment frequency — shows you how often adjustments in your interest rate will occur after the initial fixed-rate period. This is usually annual but can be dependent on the mortgage, sometimes adjusting monthly. As the borrower, a frequency on the longer side is advantageous as it allows for longer periods of stability.
• Adjustment indexes — link your ARM interest rate to a benchmark rate reflecting market conditions, causing fluctuations in your interest rate accordingly. Meaning, these fluctuations are used to justify changes in your mortgage payments over time.
• Caps — are the limits to which your interest rate can increase across each adjustment period.
• Ceiling — is the absolute maximum rate that your interest rate can reach during your entire loan term.
• Margin — represents the number of percentage points your rate can increase after your fixed-rate period ends. Once this is established in your agreement, it will not change once the loan closes.

In some cases, ARMs will have numbers like 7/6 or 5/6 in their descriptions. Note that the first figure refers to the number of years your initial rate will be fixed, and the second figure refers to the number of months between rate adjustments once that fixed-rate period is over.

Considerations with ARMs

• The future — do you plan to move or refinance before the adjustment period?
• Budget — can you handle keeping track of the fluctuating monthly payments?
• Interest rates — are mortgage rates historically high?
• Income flexibility — if your interest rate were to rise to the maximum cap, would you still be able to afford your mortgage payments?

If you answered “Yes” to these questions, an adjustable-rate mortgage might be the option for you.

Given the variety of factors involved in choosing between a fixed-rate mortgage and an adjustable-rate mortgage, understanding these pros and cons may help determine which type aligns with your financial goals and future plans.