One of the most critical decisions any home buyer must make is to choose between a fixed rate and an adjustable mortgage. While there are pros and cons to both types of home loans, fixed rate mortgages are far more popular.
According to the Consumer Financial Protection Bureau, approximately 85% of home buyers choose fixed rate loans, avoiding the risks associated with interest rate fluctuations.
The critical difference between the mortgage options is the structure for interest repayments. With a fixed rate loan, the interest rate on repayments remains the same for the full life of the loan. Adjustable rate mortgages (ARMs) initially have a lower interest rate, but it changes over time, based on current market rates, meaning it can decrease or increase.
If you’re shopping around for a mortgage, it’s essential to explore all options from multiple lenders. Although fixed rate mortgages are popular and safe long-term options, adjustable rate mortgages can help you save in the short term.
Principal and Interest
A standard mortgage payment consists of two important parts: principal and interest. The principal refers to the original loan amount received from the lender. The annual interest rate is the fee charged by your lender for providing you with financing. With a fixed rate mortgage, the annual interest rate doesn’t change. However, through a process called amortization, the mortgage repayments remain relatively consistent.
In the first few years of a mortgage, the high principal balance means that a significant percentage of your repayments cover the interest. As you pay off the principal balance over the years, the interest portion of your repayments reduces. However, this doesn’t mean your monthly mortgage payment decreases. Instead, a more significant part of your repayment goes toward the principal amount, keeping repayments consistent.
Fixed Rate Mortgages
A fixed rate mortgage charges the same interest rate for the loan’s entire life. This makes payments more predictable, facilitating easier budgeting and financial planning. While the loan balance and the amount of interest you pay each month change throughout the loan, the total repayment remains the same.
Fixed interest rate mortgages are typically available in 15, 20, or 30-year terms. 30-year mortgages are the most popular option because they offer the lowest monthly payments.
Lenders determine your annual interest rate based on risk assessment. Borrowers with strong credit scores and good credit history can benefit from low-interest rates. In contrast, poor credit use and high debt levels make competitive interest rates more difficult to secure.
Benefits of fixed rate mortgages
There are several important benefits to applying for a fixed rate mortgage:
- Predictable and consistent repayments and rates, making budgeting and personal finance management easier to control.
- Protection from interest fluctuations. If general interest rates increase after you agree on your mortgage terms, your fixed rate remains constant and doesn’t change.
- Stable payments and long-term savings make a fixed rate mortgage an excellent option for a long-term home.
- Fixed rate mortgages allow you to lock in a competitive rate in a low-interest market.
Drawbacks of fixed rate mortgages
Despite the popularity of fixed rate loans, they have some drawbacks:
- If interest rates fall after a loan has been arranged, the borrower cannot take advantage unless they refinance their mortgage.
- It can be challenging to secure competitive rates and payment arrangements from different lenders.
- Fixed rate mortgages take longer to pay off the principal loan amount. In the first few years, repayments only cover the interest. If you plan to sell your house within five to ten years, a fixed rate loan may not be a good option.
- Fixed rate mortgages are often more challenging to qualify for than adjustable loans. They also include higher closing costs and fees. Since the lender takes the hit if interest rates increase, they cover some risk with higher arrangement fees.
Adjustable Rate Mortgages
Adjustable rate mortgages (ARMs) are home loans with variable interest rates. Throughout the loan, your monthly repayments fluctuate according to the market. While this can save you money in the long term, a sharp rise in interest rates can make repayments more expensive.
When you first take out an adjustable rate mortgage, the interest rate is fixed for a certain period. You can negotiate the length of these ARM rates, with some lenders allowing you to protect interest rates for up to ten years. The mortgage resets once the fixed period ends, and a new interest rate is activated based on the current market. The newly adjusted rate is applied for an agreed period (usually one year).
One of the most popular ARM mortgages is 5/1 ARM. Under this type of agreement, the initial rate lasts for five years before being reset. After the initial adjustment frequency, the interest rate may change once a year. Other common mortgage agreements include 3/1 ARMs, 7/1 ARMS, and 10/1 ARMs.
Most lenders use mortgage caps, limiting how much the interest rate can adjust after each reset. Many of them also set an interest ceiling, identifying the maximum rate interest can climb to throughout the entire length of the loan.
Benefits of adjustable rate mortgages
Some of the key benefits of adjustable rate mortgages are:
- Lower initial interest rates when compared to fixed rate mortgages.
- It enables you to take advantage of lower interest rates without refinancing.
- It is an affordable financing option if you don’t plan on living somewhere for many years.
- You can reduce the risk of market fluctuations by initially agreeing on a longer fixed rate term.
- ARMs can be easier to qualify for as they are less risky for the lender.
Drawbacks of adjustable rate mortgages
Cons of choosing an ARM include:
- Interest rates can rise significantly throughout the loan, costing you over the long-term.
- Caps may not apply until after the first reset, which could drastically increase your monthly payments.
- Caps, margins, indexes, and market fluctuations can make ARMs difficult to understand.
- Market uncertainty and unpredictability can make financial planning and budgeting a challenge.
How to Choose the Right Mortgage
Before choosing a lender and signing for your mortgage loan, you need to consider whether a fixed rate or adjustable rate mortgage is the best choice when you buy a home.
Determine what you can afford currently
Your mortgage interest rate can significantly affect your monthly payment amount, sometimes by several hundred dollars or more. To avoid overextending yourself financially, ensure you understand how much your monthly payment will be based on the interest rates lenders are quoting you.
If you can lock in a relatively low rate for a fixed term of five years, this is an excellent option for keeping your costs consistently low for the foreseeable future. If you’re financially comfortable and can handle it if the rate rises, you may find an initial low adjustable rate is the better option for your financial situation.
Study the interest rate environment
As a borrower, it’s ideal to secure a loan during a low-interest rate environment. This occurs when the risk-free rate of interest set by the Central Bank is below average for an extended period. These low rates are great for borrowers because they mean you’re paying as close to 0% interest as possible, while they are less desirable for lenders.
If you can secure a mortgage loan at a low-interest rate, you’ll see significant financial benefits from choosing this option in the long term.
How long do you plan to stay on the property?
Fixed rate loan terms are usually the better option for homeowners who plan to stay in the home indefinitely. Opting for an adjustable rate mortgage is more beneficial if you plan to move within a few years. Otherwise, you will likely face financial penalties for selling before your term is up.
Get the Information You Need to Pick Your Rate
To learn more about whether a fixed rate or adjustable rate mortgage is the best choice for you, check out our online resources from Finance is us. We offer insight into making smart decisions regarding your mortgage, banking, and personal loan so you can improve your financial situation.
Disclaimer: All content on this site is information of a general nature and does not address the circumstances of any particular entity or individual, nor is the information a substitute for professional financial advice and services.