Becoming a homeowner is an incredible milestone that should be celebrated! Once you have decided that you are ready for this next step, it is important to prepare for the critical decisions you will need to make that determine your financing. You will be faced with the question of what type of mortgage is best for you: fixed- or adjustable rate? In this blog, we’re breaking down the key difference between these options to allow you to decide with confidence!
What Is a Fixed-Rate Mortgage?
For a fixed-rate mortgage, the interest rate remains the same throughout the entire term of the loan. This ensures that there is no change in your monthly principal and interest portion of the payments. Real Estate taxes and Insurance premiums typically increase over time. Fixed-rate mortgages provide a sense of security and allow for simplified long-term budgeting.
One of the key benefits of a fixed-rate mortgage is that it safeguards borrowers from interest rate hikes that can cause monthly payments to increase. Besides, understanding how fixed-rate mortgages function is easier when compared to adjustable-rate mortgages (ARMs).
One possible drawback of fixed-rate mortgages kicks in when interest rates are high. In addition, since the interest rate on the mortgage remains the same, you will not benefit from any cuts. You always have the option to refinance down the road if interest rates drop, but keep in mind that you will face closing costs. After refinancing, you have a new loan.
The total interest you end up paying throughout the course of the loan depends on its term. The most common loan terms include 10, 20, and 30 years. If you’re looking to pay off your mortgage aggressively, a 10-year term is best for you. However, the monthly payments will be much higher than if you choose a 30-year term. The longer the term, the more you will pay in interest. You can make additional principal payments during the term of the loan to shorten the total term and interest paid.
What Is an Adjustable-Rate Mortgage?
As the name implies, the interest rate on an adjustable-rate mortgage is subject to change based on the market. Lenders rely on two basic numbers to determine which way they need to adjust their interest rates. These include the index rate and the margin.
- Index rate. The index rate is a benchmark that has a direct bearing on your ARM’s interest rate. Some of the factors that affect the index rate include treasury yields, the Cost of Funds Index (COFI), the Secured Overnight Financing Rate (SOFR), and the prime rate.
- Margin. The margin is the mark-up that a lender adds to the index rate and it accounts for the risk the lender is willing to take to grant you a loan.
Why Index Rates Change
Index rates can change based on different economic factors including but not limited to:
- Inflation. If inflation increases, the Federal Reserve may hike interest rates to cool down the economy. This can cause index rates to rise, and consequently, your ARM rate to go up.
- Demand. When there’s a high demand for mortgages, lenders may raise index rates to manage risk.
- Global market conditions. Global economic events can have a negative impact on index rates.
How ARMs Work
The interest rate attached to an ARM is typically lower than that of a comparable fixed-rate mortgage during the initial period which may vary from one to ten years. Once this predetermined period ends, the interest rate can go up or down depending on market conditions. In the long run, the interest rate of an ARM can surpass that of a comparable fixed-rate mortgage.
Once the initial period ends, your ARM’s rate begins adjusting at regular intervals. Here are the most common types of ARMs based on the frequency of adjustments.
- 1/1 ARM. Not commonly found, the interest rate of this ARM remains the same for the first year and changes every year thereafter.
- 3/1 ARM. There is no change in the interest rate during the first year, after which is it is subject to change every year.
- 3/6 ARM. Interest rate adjustments take place every six months after the three-year fixed rate period.
- 5/1 ARM. The interest rate remains fixed for the first five years and adjusts annually thereafter.
- 5/6 ARM. Adjustments happen every six months after the initial five-year fixed period.
- 7/1 ARM.A fixed rate applies for the first seven years, followed by yearly adjustments.
- 7/6 ARM. You get a fixed rate for the first seven years, followed by adjustments that occur every six months.
- 10/1 ARM. A 10/1 ARM comes with a 10-year fixed-rate period before annual adjustments begin.
- 10/6 ARM. Adjustments take place every six months after the initial 10-year period.
Caps on ARMs
You may think of caps on ARMs like safety nets, limiting how much the interest rate and your monthly payments can fluctuate throughout the loan’s term.
- Initial adjustment cap. This limits the increase in interest rate during the first adjustment period. For example, if your ARM has a 5% initial adjustment cap, your interest rate can’t jump more than 5% from the initial fixed rate at the first adjustment.
- Periodic adjustment cap. This restricts any increase or decrease during each adjustment period after the initial fixed rate ends. Typically denoted as a percentage, it applies to each adjustment period throughout the loan.
- Lifetime cap. The lifetime cap determines the maximum and minimum interest rate you’ll pay over the entire life of the loan, ensuring your rate won’t skyrocket even if market rates climb significantly.
ARMs with lower initial and periodic adjustment caps tend to come with higher initial interest rates because lenders take on less risk by limiting how much they can adjust the rate. On the other hand, ARMs with higher caps offer more flexibility for the interest rate to adjust with the market. However, this can lead to potentially higher monthly payments down the line.
If you’re thinking about getting an ARM, it’s crucial to understand the specific caps that apply to your mortgage, and you may benefit by asking your lender these questions.
- What are the initial, periodic, and lifetime adjustment caps?
- How do the caps affect the initial interest rate?
- How would the caps limit rate adjustments over time?
Fixed-Rate vs. Adjustable-Rate Mortgages: The Similarities
A close look at the ARM vs. fixed-rate mortgage comparison shows you that both come with some similarities.
- Loan term. Whether you opt for an adjustable- or a fixed-rate mortgage, you get to choose from different loan terms, typically ranging from 15 to 30 years. A shorter term means a higher monthly payment and faster payoff, while a longer term offers lower payments and extends the interest-paying period.
- Eligibility. Getting approved for either loan usually requires a good credit score and a sound financial situation. Bear in mind that lenders assess your income, debt-to-income ratio, and overall financial stability to determine your eligibility and interest rate.
- Ability to refinance. The option to refinance your mortgage exists no matter which of the two you select. This can be particularly beneficial if you wish to refinance an ARM before its interest rate resets.
Adjustable- vs. Fixed-Rate Mortgages: The Differences
The key difference that stands out in the adjustable- vs. fixed-rate mortgage comparison is what happens to the interest rate through the course of the loan’s term. While it remains the same for as long as you have a fixed-rate mortgage, it becomes subject to periodic adjustments with an ARM after the initial fixed-rate period ends. Looking at the pros and cons of each type sheds more light on their differences.
Adjustable-Rate Mortgage: Pros and Cons
It is common for potential borrowers to ask “What is the main advantage of an adjustable-rate mortgage?” Here are the benefits on offer.
- Lower interest rate during the initial period when compared to a fixed-rate mortgage.
- Favorable market conditions may lead to lower interest rates down the line.
- Lower initial payments can make qualifying for a loan easier.
What is the big disadvantage of an adjustable-rate mortgage? One potential drawback is that your interest rate and monthly payments might go up significantly over time owing to rate adjustments. Besides, since your regular principal and interest payments may change frequently, it might be challenging to create a budget for the long term.
Fixed-Rate Mortgage: Pros and Cons
Factors that work in the favor of fixed-rate mortgages include:
- The interest rate will not increase with time.
- Planning and budgeting are easier because your monthly payments remain the same.
- You might be able to make a smaller down payment when compared to an adjustable-rate mortgage.
The benefits notwithstanding, understanding the potential shortcomings of fixed-rate mortgages is also important. For instance, you’ll need to refinance your mortgage to take advantage of falling interest rates. In addition, you might end up paying a tidy sum as interest if you get a fixed-rate mortgage when interest rates are high.
Which Should You Get?
While looking at the adjustable- vs. fixed-mortgage comparison is important, you need to understand that this aspect comes into play based on the type of mortgage you wish to get and the lender you select. For example, with mortgages offered under the U.S. Department of Agriculture’s Single Family Housing Guaranteed Loan Program (SFHGLP), you don’t get the option of ARMs. However, the option exists with conforming loans, as well as VA loans.
Why Fixed-Rate Mortgages Are Better?
While not always the case, getting a fixed-rate mortgage can work better than an ARM in different scenarios.
- Buying for the long-term. If you plan to live in the home you purchase over the long term, a fixed-rate mortgage can bring with it a sense of budgetary stability. You can still make additional payments to repay your loan ahead of time.
- On a tight budget. If you’re on a tight budget, any increase in interest rates can affect your ability to make higher monthly payments, making a fixed-rate mortgage a safer bet.
- Favorable market conditions. When prevailing home loan interest rates are low, you may look forward to long-term savings by locking in a low rate. This can be the case even if the rate you pay is higher than the rate of a comparable ARM at that point because the latter can increase with time.
When Can Adjustable-Rate Mortgages Be Better?
Given that an ARM starts out with a lower interest rate than a fixed-rate mortgage, you get some leeway in making additional payments to bring down the principal amount early on. You may benefit by getting an ARM in a few other scenarios too.
- Not buying a long-term home. If you plan to move out of the home you purchase before the introductory fixed-rate period ends, an ARM can save you money. This is because you can enjoy a lower rate while you’re there, and if you move before it adjusts, you haven’t locked yourself into a potentially unfavorable rate for a prolonged period.
- Fall in interest rates. If interest rates are currently high and expected to fall, an ARM can be a gamble that pays off. As rates drop, so will your ARM’s interest rate, potentially saving you thousands over the life of the loan. However, remember, that ARMs are akin to double-edged swords; if interest rates rise, so will your payments.
- Flipping. If you’re buying a house with the intention of fixing and flipping it soon, the money you save from an ARM’s lower initial rate can leave with you extra funds to carry out the required repairs and renovations.
- Increase in income. If you foresee your income to increase noticeably in the times to come, you might be able to withstand the risk that comes with an ARM. This is because you will be able to make higher monthly payments, should the need arise.
Conclusion
Now that you know how to determine if a fixed- or adjustable-rate mortgage is better for you, take time to look at the types of mortgages for which you might qualify. For example, if you or your spouse is serving or has served in the U.S. military, you might be eligible to get a VA loan without making any down payment. If you’re still unsure about which way to proceed, discussing your specific situation and requirements with a reputed mortgage provider can help you make your decision.
