Fixed Rate Mortgage vs Adjustable Rate Mortgage: What's The Difference

Real Estate Agent with RE/MAX Executive Realty 91362

Comparing Fixed and Adjustable Rate Mortgages

When you are looking for a mortgage, there are two main types you will encounter; fixed-rate and adjustable rate mortgages. Lenders will offer many different home loan choices within these categories, but you need to choose whether an adjustable or fixed rate is better for you.

Let’s look at the differences between these home loan types, so it’s easier to choose between them.

What is a Fixed-Rate Mortgage?

If you get a fixed-rate home loan your interest rate will remain constant. Your mortgage payment will stay the same each month, though the amount of interest and the principal you pay will change within that payment.

The fixed rate makes budgeting simple, but it does mean that most of the monthly mortgage payments in the early years will go towards interest. Gradually, this situation will change, increasing the amount of the principal that is paid.

While having regular fixed mortgage payments might be attractive, it does mean higher interest rates. This can make qualifying for the loan more difficult as well due to higher monthly payments.

Even though the interest rate stays the same throughout the loan, the amount of interest you will pay depends on the mortgage term. Typical mortgage terms range from 15 to 30 years, and while a 30-year mortgage does offer lower monthly payments, it will be considerably more expensive than a 15-year loan.

For the majority of the extra years, the borrower will mostly be paying interest on the home loan each month.

However, a shorter-term home loan with higher monthly payments allows the principal to be paid down faster. As a result, the overall cost of a 15-year mortgage is far less than a 30-year loan.

What is an Adjustable Rate Mortgage?

With an adjustable rate loan, the interest rate is variable after a certain amount of time. At the beginning of the variable rate loan term, the interest rate will be lower than a similar fixed-rate mortgage, but this situation does not stay the same.

When the ARM is continued beyond the initial fixed interest period, interest on the loan will likely increase. The interest rate could change at fixed intervals set out in the terms of the contract. The amount of time the fixed period lasts can vary and could be as long as 10 years, but as little as a few months.

When the fixed period is over, the interest will reset to a rate based on the current market rates. The borrower will continue to make mortgage payments based on this new rate until it resets again. The next interest reset could be a year away, but it might be much sooner.

Surprisingly, there are no additional down payment requirements when utilizing an adjustable rate mortgage.

The credit score requirements for buying a house also do not change when using an adjustable vs. fixed rate.

Understanding ARMs

There is more to understand about an adjustable rate mortgage than the fixed-rate equivalent. Before you decide which type of home loan is right for you, understanding the terminology is important. Let’s review the terms you need to understand before choosing an ARM.

  • Adjustment frequency: The time between rate adjustments. This might be monthly, every six months, or yearly.
  • Adjustment indexes: When the interest rate resets, the new rate is based on a benchmark index. ARMs can use different indexes as their benchmark, like the Secured Overnight Financing Rate or assets like Treasury bills, for example.
  • Margin: Applying for an ARM means agreeing to an interest rate above the benchmark. The margin is the difference between the benchmark rate and what you will pay.
  • Caps: While the interest can change on a regular basis, there can be a limit to how much it can change. This protects homeowners from steep increases in their monthly payments. These mortgages can be known as negative amortization loans and will ensure monthly payments don’t get too high. However, this means only paying some of the interest that should be paid, and instead, the difference is added to the principal. In extreme circumstances, this can lead to the principal growing to more than the original loan years after the mortgage began.
  • Ceiling: This is the maximum allowable interest rate that you will pay.

A variable rate loan gives borrowers the chance of low monthly payments for the first few years of the mortgage, but there are downsides.

You could find yourself in a situation where you suddenly find you have a lot more to pay when the initial period ends.

Many borrowers found themselves in this situation when the subprime mortgage crisis hit. When their fixed period ended, they found the monthly payments were suddenly not affordable for them. As a consequence, new regulations have been instituted to prevent predatory lending.

Choosing the Right Loan Type

Many things should go into deciding which type of mortgage you should choose. Your financial situation, as well as the economic outlook, and the amount of time you expect to live in the home are all important factors.

Interest rates can rise and fall, and if you lock in a lower rate before things start to rise, you will save on your mortgage costs. The direction the economy is heading is something you need to consider for this reason.

The amount of time you expect to live in the home is another factor. If you don’t expect to be there for long, you could sell the home before the fixed rate period ends.

What Types of Borrowers Best Suit ARMs?

Short-Term Owners

If you expect to move after only a few years, you could benefit from the low fixed term period. It will save you a lot compared to having a fixed-rate mortgage for the same amount of time.

Paying Off the Loan Quickly

If you expect to pay off the mortgage within the fixed period, an ARM is a great choice. This could happen if you are waiting for your old home to sell, and when it does, you can use the money to pay off the ARM.

Increasing Income

If you expect your income to improve, perhaps as a result of graduating with a degree, you should be able to afford increased mortgage payments in a few years.

Final Thoughts

Depending on your circumstances, choosing an ARM can be a great decision. Though it isn’t going to be the right choice in many situations, you need to carefully consider your options before you commit.

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With three decades of experience, Bill Gassett is an authority in the real estate sector. Bill writes informative articles for numerous prestigious real estate sites to help buyers, sellers, and fellow real estate agents. His work has been featured on RIS Media, the National Association of Realtors, Inman News, Placester, Realty Biz News, Credit Sesame, and his own authority resource, Maximum Real Estate Exposure. Reach out to Bill Gassett for his real estate, mortgage, and financial expertise.

Comments (1)

Richard Weeks
Dallas, TX
REALTOR®, Broker

Great information, thanks for sharing.  I hope you have a great day.

Aug 15, 2022 02:14 AM