Adjustable-Rate or Fixed-Rate: Which Type of Mortgage is Right for You?
Reading time: 4 Minutes
February 14th, 2020
Buying a home is exciting! But making that dream a reality usually involves getting a mortgage, which can sometimes seem confusing and stressful. Not only are there hundreds of mortgage lenders to choose from, but each will likely offer different types of mortgages with different rates, terms and features. So how do you decide which kind of mortgage is right for you?
The multitude of options can be boiled down to two main kinds of mortgages: fixed-rate and adjustable-rate. Choosing the one that is right for you can also be determined by answering two simple questions:
- How long do I expect to live in this house? Is it my forever home, or will I be moving again in a few years?
- Do I feel comfortable with getting a lower interest rate if it means that it might increase in the future?
Think about how you might answer these questions, and keep those answers in mind as you read further.
What’s a Fixed-Rate Mortgage?
As the name implies, the interest rate, and thus the monthly payment, of a fixed-rate mortgage are set at the time you take out the mortgage and remain constant throughout the course of your loan. Many people find having a consistent payment plan reassuring. This is because you can better manage other aspects of your finances, and make long-term financial plans without worrying about your mortgage payment growing out of control.
Each monthly payment is composed of both principal (the money you originally borrowed) and interest (the amount your lender charges you to borrow that money). Payments made early in the life of your mortgage are applied primarily to the interest. As the interest is paid down, payments are then applied mostly to the principal.
Most institutions offer fixed-rate mortgages of 30 and 15 years. What’s the benefit of the shorter mortgage? You pay off your mortgage in half the time, paying less interest over the course of your loan. The catch? Your monthly payments will be higher.
Choosing the terms of a fixed-rate mortgage is usually based on the monthly payments you can afford as well as how quickly you want to pay off the entire loan.
Why You Might Want a Fixed-Rate Mortgage Loan:
If you’re planning on staying in your home for the foreseeable future, and mortgage rates are relatively low, it can be a good idea to lock everything in with a fixed-rate mortgage.
What’s an Adjustable-Rate Mortgage?
Adjustable-rate mortgages (or ARMs) usually have lower starting interest rates, compared with fixed-rate mortgages. However, with an adjustable-rate mortgage, your interest rate—and monthly payments—can change as interest rates fluctuate.
If you’re considering this type of mortgage, there are several details you’ll need to understand:
Initial rate is the period of time during which your rate is fixed at a lower rate. Generally, the initial rate period lasts 3, 5 or 7 years. You’ll need to decide which initial rate period is best for your situation. After that timeframe, the interest on your loan will be adjusted based on the terms of the mortgage, typically annually or semi-annually.
Index and margin
ARM rates are usually based on a published benchmark index which reflects the general interest-rate market, then adjusted with a pre-established margin set by the individual lender. You won’t have control over the index, but you can generally negotiate on the margin, so it’s worth asking.
The good news is, most ARMs have a limit to how high their interest rates can rise in one year—or even over the course of the entire mortgage. Knowing your mortgage cap can help you figure out your worst-case scenario if rates rise at the maximum rate allowed.
Why You Might Want an Adjustable-Rate Mortgage Loan
One good way to use an adjustable-rate mortgage is if you don’t plan on staying in your home for more than a few years. You’ll be able to benefit from the low introductory rate, and will most likely be able to sell the house before rates rise too much.
You might also want to consider an ARM if mortgage interest rates are currently high, and you expect them to fall at some point in the relatively near future. This means you would benefit from the shrinking rate environment, instead of having to refinance a fixed-rate mortgage to get those savings.
Expert Help is Available
Essentially, a mortgage is a loan in which your house is the collateral, one you’ll most likely be paying off for decades. So it's important to fully understand and feel comfortable with the terms of your agreement—to make sure the loan terms work for you. It can be a confusing process and you’ll likely want some guidance along the way—be sure to reach out to your loan officer as you start to consider your options. They’ll be able to answer just about any question you might have. Happy house hunting!
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