Fixed-rate vs. adjustable-rate mortgage
The difference between fixed and adjustable-rate mortgages is whether the interest rate is fixed for a set period of time, or it adjusts during the term of the loan.
A fixed-rate mortgage is a type of mortgage loan with an interest rate that doesn't change over the course of the loan.
An adjustable-rate mortgage (also known as an ARM) has an interest rate that changes (up or down depending on various factors) over the course of the loan.
Depending on your financial situation and real estate goals, it may be better to get a fixed-rate mortgage. When it comes to fixed rate vs. adjustable-rate mortgages, buyers like fixed-rate mortgages because the monthly mortgage payments will be the same each month, so budgeting is easy. However, some buyers prefer and may benefit from getting an adjustable-rate mortgage.
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Read on to learn more about ARM vs. fixed mortgages.
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What is a fixed-rate mortgage?
A fixed-rate mortgage is a type of mortgage loan with an interest rate that doesn't change over the course of the loan. If you get a 30-year mortgage at 4.25%, this is the interest rate and term you will keep for the 30-year loan term, unless you decide to refinance the mortgage to another interest rate and/or term. Homeowners like fixed-rate mortgages because of the stability and predictability of the monthly payment.
Learn more about how fixed rate mortgages work.
What is an adjustable-rate mortgage?
As mentioned, an adjustable-rate mortgage (also known as an ARM) has an interest rate that changes (up or down depending on various factors) over the course of the loan.
Learn more about how an adjustable-rate mortgage works.
ARM terms to know
ARMs have some unique terminology that homebuyers should be aware of. Here are some of the key terms:
Adjustment frequency. Also known as the “reset date,” the adjustment frequency is how often the interest rate changes on a particular ARM. Most ARMs adjust annually, however, some adjust monthly, quarterly, at three years or at five years.
Adjustment indexes. There are many market indexes that an ARM can follow. These indexes include London Interbank Offered Rate (LIBOR), Secured Overnight Financing Rate (SOFR), Federal Cost of Funds Index (COFI), Constant maturity treasury (CMT), the Prime Rate (the interest rate that banks use to set interest rates for loans), and a U.S. Treasury Bill rate.
Margin. This is the number of percentage points the mortgage lender adds to the index.
Adjustable Interest rate caps. Although ARM interest fluctuates, all ARMs come with a cap or maximum threshold. The interest rate cap structure is how the mortgage lender structures the different types of rate caps. All lenders must disclose how their ARM loan caps are structured. The caps protect the borrower from large interest rate swings.
Lifetime cap or ceiling. This is how much the interest rate can increase in total, over the
life of the loan.
Pros and cons of fixed-rate mortgages
Pros:
- Interest Rate never changes. The interest rate is fixed for a long term, generally 30, 20, 15 or 10 years.
- Predictable payments. A fixed interest rate means that monthly payments will be the same throughout the term you choose.
- Better for long-term homeowners. The longer you plan to keep your home, the better it is to choose a fixed-rate mortgage. If interest rates go down it’s easy to refinance or refinance and get cash out.
Cons:
- Potentially higher rates than adjustable-rate loans. Lenders typically charge higher interest rates on fixed-rate mortgages.
- More expensive. The longer loan term means you’ll pay more in interest over the life of the loan.
- Harder to qualify for. Because rates are usually higher for fixed-rate loans, qualifying can be harder due to the lending criteria. Some buyers may not be able to afford a mortgage with a higher interest rate because of the larger monthly loan payment.
- Not as good for short-term homeowners. If you are buying a home to live in for just a couple of years or to renovate and sell (fix-and-flip), then an ARM can save you money in interest payments. You’ll have the property sold before the rate adjusts higher and, in the meantime, you’ll pay a lower interest rate.
- Can't take advantage of lower interest rates. Having a fixed rate is great when interest rates rise, and you benefit from a low-range rate. But if interest rates go very low, you miss out on that opportunity (unless you refinance to a lower rate).
Pros and cons of adjustable-rate mortgages
Pros:
- Lower initial interest rate. This lower initial rate makes ARMs very attractive. This provides time to do renovations or potentially earn more income, so when the rate adjusts higher, you’ll be in a stronger financial position.
- Lower monthly payments. ARMs come with a low introductory rate, which means lower monthly payments. Even when the rate adjusts higher you may end up with a lower rate than you may have had with a fixed-rate loan.
- Better for short-term homeowners. Starting with a low rate will save you money if you don’t plan to keep the house for many years.
Cons:
- Unpredictable and complex. ARMs are not for homeowners who enjoy predictability in their financial endeavors. Although ARMs come with a rate cap, they are more complex than fixed-rate mortgages and many homeowners are surprised when it comes time for the rate to reset higher.
- Prepayment penalty. Some ARMs come with a prepayment penalty that the lender will charge if you sell the home and pay off the mortgage or refinance the loan before a certain period.
- Payment increases. Because the rate is adjustable, you’ll need to be prepared for monthly payments to go up periodically.
Which mortgage type should I choose?
Many homebuyers ask, which is better fixed or an adjustable-rate mortgage? As we've discussed, both types have their pros and cons. The type of loan you choose is a personal decision based on your financial situation and financial and real estate ownership goals. Your mortgage specialist can help you weigh the options. In the meantime, here are some important questions to ask yourself.
Questions to ask yourself
Before you start your home search and before you get pre-qualified or pre-approved for a mortgage, ask yourself these questions. Your answers will help you choose between a fixed rate vs. adjustable rate mortgage.
- Do I plan on living in my home for a long time? The length of time you plan to stay in the home is a main determinant of the type of mortgage to choose. If you plan to live there many years, a 30-year fixed rate mortgage is best. If you plan to live there a short time, consider an ARM. You’ll get the best rate advantages in the short-term before the ARM rate adjusts higher.
- Am I close to retiring? If you’ll be retiring soon and plan to stay in the home, a fixed-rate mortgage is a good idea, due to the stability and predictability of expenses. This is important for retirees on a fixed retirement income.
- What are the current mortgage interest rates? If current mortgage interest rates are high, consider an ARM. Because the interest rate starts lower than a fixed-rate mortgage you can keep the low ARM rate for a short term, then refinance to a fixed rate when the rates go down.
- Do I expect to earn more money soon? If your income will stay the same, then a fixed-rate mortgage is best for stable payments. If you expect your income to rise, then an ARM is best, as it allows you to benefit from the low initial interest rate.
- Do I plan on paying off my mortgage early? Both a fixed-rate and ARM could work in this situation. While the fixed-rate loan may have a higher interest rate, fixed-rate loans rarely have a pre-payment penalty; keep the loan if you need it. Most ARMs do have a prepayment penalty, so if you plan to pay off the mortgage early ask your lender what the penalties are for doing so.
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