Fixed-Rate or Adjustable-Rate Mortgages – Which is Better?

What is a Fixed-Rate Mortgage?

 

A fixed-rate mortgage is a mortgage that you pay back with a fixed interest rate. Unlike adjustable-rate mortgages, the interest rate is set from the start and does not change during the life of the loan. That doesn’t mean every repayment is the same; the amount paid towards principal and interest changes every month. But the total interest rate you must pay back usually remains the same.

 

Your repayments for a fixed-rate mortgage may be predictable, but they are not completely fixed. The total amount you pay back in interest will also depend on the mortgage term. Common mortgage terms from traditional lenders are normally 15, 20, or 30 years. 30-year mortgages are the most popular and usually offer the borrower the lowest monthly payments because of how long the repayment term is stretched out. The trade-off is that your total interest payments for the life of the loan will usually be higher, as the extra decade in a 30-year mortgage is typically used for paying off interest.

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Pros of a Fixed-Rate Mortgage 

 

  • Fixed-rate mortgages should be more predictable than adjustable-rate mortgages. It doesn’t matter if interest rates rise because you will end up paying the same interest rate anyway. 
  • For some people, fixed interest rates make budgeting simpler, as you don’t need to factor in any sudden changes to your monthly payments if interest rates rise. For some people, they are easier to understand and are less complex than adjustable-rate mortgages.
  • You still have a choice in repayment terms when you want a fixed-rate mortgage. You can choose a short-term fixed-rate mortgage for higher monthly repayments but spend less long-term. Or you can get a long-term fixed-rate mortgage for lower monthly repayments at the expense of a higher overall cost.

 

 

Cons of a Fixed-Rate Mortgage 

 

  • Fixed-rate mortgages can be harder to qualify for under some conditions. When interest rates are high, repayments are higher, making those repayments less affordable. At these times, fixed-rate mortgages can cost more in interest than adjustable-rate or interest-only mortgages. 
  • If you do get a fixed-rate mortgage when rates are high, you’re stuck with the higher rate, while borrowers with adjustable-rate mortgages will benefit if interest rates fall. If you don’t refinance, you stand a chance of paying much more by the time your mortgage matures.

What is an Adjustable-Rate Mortgage?

 An Adjustable-rate mortgage (ARM) is a mortgage with interest rates that can adjust periodically. That means your monthly repayments can go up or down many times during the life of your mortgage. The rate that they follow is based on market forces and follows an index that it remains tied to.

 

There are different indexes for determining interest rates for adjustable-rate mortgages. Your loan documents will always lay out which index the adjustable-rate mortgage will follow.

 

Overall, adjustable-rate mortgages are unpredictable simply because interest rates are unpredictable. During the Covid-19 pandemic, interest rates have fallen to historic lows. 

 

Beyond interest rates, the adjustment period of an adjustable-rate mortgage is also important to some people. This is the case when you take a hybrid adjustable-rate mortgage. These ARMs come with a fixed rate for a specified number of years, then adjust annually. For example, the popular 5/1 ARM comes with an introductory interest rate which first adjusts after the first 5 years. After that, rates adjust annually. Other lenders will offer 3/1, 7/1, or even 10/1 ARMs. If the interest rate you find right now is very good, it could potentially be beneficial to lock it in for a longer introductory period.

 

Pros of an Adjustable-Rate Mortgage  

  • You can normally pay less in interest during the early phases of an ARM. The initial lower payments are factored in during the qualification process. This allows some borrowers to afford homes that are more expensive than they could otherwise afford.
  • Borrowers can benefit from falling interest rates. If you have a fixed-rate mortgage at a time when interest rates are dropping fast, you cannot benefit from the falling rates unless you refinance your mortgage. With an ARM, you benefit from falling rates once your regular rate adjustment takes place.
  • Financially, ARMs can help borrowers who don’t plan on staying in a home forever. If you secure low initial rates, you can end up paying far less during the first few years than you would with a fixed-rate mortgage. 

 

Cons of an Adjustable-Rate Mortgage 

  • Rate adjustments can go in either direction and you have no control over the adjustment schedule you agree to when you sign a loan contract. If rates rise significantly ahead of your adjustment, you will end up having to make larger repayments and pay more interest overall. In some cases, rates can rise throughout the life of your mortgage. This can stretch your budget if you’re not prepared.
  • While ARMs come with adjustment caps to ensure rates don’t rise too fast, you’re not always as protected as you need to be. Some annual caps aren’t applied to the first-rate adjustment, for example. 
  • ARMs are quite complex when compared to fixed-rate mortgages. Lenders also have a lot of leeway when it comes to determining factors like adjustment caps and indexes. For some borrowers, this can lead to confusion or agreeing to terms that they don’t truly understand.

Adjustable vs. Fixed Rate: Which Should I Choose?

The right mortgage for you could be one or the other. For most people, the best mortgages are the ones that help them get the house they need at a cost they can afford. Fixed-rate mortgages can help get that in a more predictable way usually, but adjustable-rate mortgages can end up being a cheaper deal in some circumstances. That’s why taking the time to compare rates and terms between mortgages of both types is something that many people choose to do.

Example of ARM vs Fixed

  30-year Fixed-rate 5/1 ARM
Mortgage amount $200,000 $200,000
Interest rate 3% 2.75%
Principal & Interest $674 monthly $653 per month for first 5 years; rates adjust annually after

  

*Both examples assume a 20% down payment

How long do you plan on staying in the home?

The length of time you plan on staying in a home before moving out can change the dynamics of what a “good” mortgage would be. Often, ARMs offer lower rates for the first few years, making many of them a more affordable short-term option. But if someone wants to stay in a home for more than 30 years and values stability/predictability, a fixed-rate mortgage might be preferable.

How frequently does the ARM adjust, and when?

Normally, an ARM will have an initial period during which there are no adjustments. For example, a 5/1 ARM will have 5 years without any adjustments. After that initial period, rates adjust annually according to the index the loan documents reference. Your lender’s documents specify the adjustment schedule. Rates adjust according to that schedule for the life of the loan. 

What’s the interest rate environment like?

Interest rates can be subject to change in any direction. There are no guarantees that interest rates will change or stay the same.

Recently, the interest rate environment has been characterized by lower than usual rates. According to data from Freddie Mac, late 2020 saw interest rates fall below 3% for the first time in decades. The Covid-19 pandemic has coincided with historically low interest rates. Throughout 2021, rates have hovered close to the 3% mark, occasionally dipping below that. During the last decade, rates have normally fluctuated between 3% and 6%.

ARMs have fallen to even lower rates recently. 2021 has seen ARM rates steadily stay well below 3%.

Could you still afford your monthly payment if interest rates rise significantly?

This question can only be answered by individual borrowers. It is an individual responsibility to understand the terms of an ARM and be prepared for possible adjustments. ARM adjustments come with caps, but maybe readjusted to a higher rate, up to the adjustment cap. It’s important to understand that so you can avoid facing payments that you can no longer afford.

ARM And FRM Terms You Should Know

The mortgage industry has its own vocabulary. Here are some of the most common and important phrases you will come across.

 Adjustment cap
  The limit of how high an interest rate can rise during a single adjustment period on an ARM

Adjustment date
The date during which an ARM rate will be adjusted.

Adjustment period
The period of time between rate adjustments.

Amortization Term
Amortization is the gradual reduction of principal you owe to your lender. The amortization term is the length of time required to amortize your mortgage.

Base rate
“Base rate” refers to the rate which is used as an index for interest rates.

Cap
The limit for how high adjustable interest rates can increase. There are normally annual and lifetime caps for ARMs.

Ceiling rate
  The absolute maximum rate your can face with an ARM.

Convertibility clause
Some ARMs come with a clause that enables the borrower to convert their ARM into a fixed-rate mortgage.

Convertible ARM
An ARM with a convertibility clause that allows conversion under specified circumstances.

Cost of Funds Index (COFI)
The index that is used for changes to interest rates for some ARMs.

Initial rate
The starting interest rate for an ARM prior to the first adjustment. 

Interest rate cap
The limit on how far an adjustable interest rate can increase during a single adjustment.

Lifetime adjustment cap
The maximum adjustment for the entire term of an ARM.

Option ARM
A type of ARM where the borrower can choose from 4 monthly payment options, providing increased flexibility.

Payment cap
A limit on one-time payment increases. Payment caps are separate from and are applied alongside interest rate caps.

Payment change date
The date on which a new payment amount is required for an ARM.

Start rate
The starting interest rate for an ARM.

Treasury index
The treasury index is used to determine interest rates for some ARMs. The index follows auctions for treasury bills and securities derived from the US Treasury’s daily yield curve.

Fixed-rate option
An option available on some mortgages. Borrowers may fix outstanding principal or interest payments for a specific term, often for a fee.

Rate lock
A fixed number of days during which the interest rate for an ARM is locked in. Rate locks are guarantees from lenders that come with a specified period. Once the rate lock expires, the interest rate is again subject to market fluctuations.

Rate reduction option
Some ARMs offer an option to reduce the interest rate sometime during the mortgage term without having to refinance. You don’t normally need to qualify for refinancing to take advantage of a rate reduction option.

Variable-rate monthly minimum payment
The minimum amount you must pay monthly on an ARM. “Variable-rate monthly minimum payment” is often applied to HELOCs.

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