Buying a home is a long-term investment, so it’s important to find a financing option that fits your needs and preferences. When it comes to home loans, there are plenty of options — there’s no one-size-fits-all mortgage type. One decision you may make is choosing between a fixed-rate and an adjustable-rate mortgage (ARM).
If you want a fixed mortgage rate and monthly payment, a fixed-rate mortgage is the way to go. If you’re looking for a flexible mortgage product with a lower initial rate, however, an adjustable-rate mortgage likely suits you better. Read on to learn more about the differences between the two, including the pros and cons of both.
An adjustable-rate mortgage, also known as an ARM, has a fixed initial rate (often below the market’s current rate). Once the specified fixed-rate period is up, the interest rate changes at a predetermined frequency. The initial fixed-rate period varies significantly — it can be less than a year for some borrowers and 10 years for others.
If you have a shorter adjustment period, you may have a lower initial interest rate. Once the initial term is over, though, the loan rate resets. Your new rate will be based on current market rates and will remain until a new rate sets in.
Adjustable-rate mortgage pros and cons
One advantage of this type of loan is the lower initial rate, which can save you a significant amount on your monthly payments at the beginning. This could make an ARM the right choice for you if you don’t plan to live in the property you’re buying for long.
ARMs usually come with a three- to seven-year fixed-rate period, then the rate adjusts at specified periods afterward. If you sell or refinance your property before this time limit, you can save a lot on the total interest cost and monthly payment.
ARMs can be risky, though. If you occupy the property long enough for the rate to increase significantly, you’ll have to pay more overall in monthly payments and interest. Plus, budgeting for your loan can be difficult when you don’t know what rates to expect. Fortunately, ARMs usually have payment or interest rate caps.
- Lower initial interest rate
- Interest rate could decrease
- Caps on rate and payment
- Advantages for short-term homeowners
- Interest rate, monthly payment can increase over time
- Payments are unpredictable
- Can be more difficult to understand
Adjustable-rate mortgages are a bit more difficult to grasp than fixed-rate mortgages. If you’re considering an ARM, it’s important to learn all the nuances and related vocabulary.
Adjustment frequency: This is the frequency of rate adjustments. The adjustment frequency on an ARM might be monthly, yearly or every few years.
Adjustment index: The adjustment index is a benchmark interest rate based on market conditions that is used as part of the calculation for your new interest rate on an ARM. The index used depends on the lender; two common indexes are the U.S. prime rate and the Constant Maturity Treasury rate.
Interest caps: Interest caps are limits on the interest rate increase in a given adjustment period. Some ARMs have payment caps.
Interest-only ARM: An interest-only ARM requires you to pay only your interest portion monthly for a fixed period. After this period, your loan amortizes, meaning your monthly payments increase so you can pay off the mortgage before its term is up.
Margin: The margin is the other component (with the index) used to calculate your adjustable rate. The margin is added to the index to set the new rate. It is set in the loan agreement and is a number of percentage points.
When you opt for a fixed-rate mortgage, you’ll pay a set interest rate that remains unchanged throughout the life of your loan. Though the monthly interest and principal vary in terms of payments, the total monthly payment doesn’t change. This makes budgeting easy to manage.
One of the main advantages of a fixed-rate loan is that there’s no sudden or significant increase in your monthly mortgage payments, even if there’s an increase in the overall market. Plus, fixed-rate mortgages are simpler to understand.
However, fixed-rate terms vary from bank to bank, and qualifying can be more difficult if the interest rates are higher (monthly payments increase with interest).
Fixed-rate mortgage pros and cons
Most people choose a fixed-rate mortgage because it’s straightforward, consistent and more stable than an ARM. With a fixed-rate loan, there are no surprise rate increases, and budgeting is simpler.
Fixed-rate mortgages also come with long term options (typically up to 30 years). A longer term can mean smaller monthly payments, which makes homeownership more attainable for many borrowers.
One downside: Rates for this type of loan tend to be higher than what ARMs offer during the initial years. That means you have to pay a higher monthly payment and interest rate at the beginning, which isn’t to your benefit if you only plan to spend a short time in the property.
- Monthly payments stay the same
- Less complicated than ARM
- Can save long-term homeowners money
- Interest rates typically higher than ARMs to start
- Might be less cost-efficient for short-term borrowers
- Market rates may fall
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