Buying a home is one of the most important purchases a person makes in their lifetime. And therefore, it’s paramount that the mortgage one attains is the right type of loan for their financial needs. When deciding on a mortgage loan, one of the first decisions you’ll have to make is whether you want a fixed-rate loan or an adjustable-rate mortgage (ARM). Each type of mortgage comes with benefits, drawbacks and idiosyncrasies. Let’s compare both and break down when either could be better for you.
If you’re planning to buy a home, a financial advisor can help you create a financial plan you reach your home buying goals.
A fixed-rate mortgage has a fixed interest rate. Once you sign on the dotted line, you’ll know beyond a shadow of a doubt what your interest rate will be on the first and last day of your loan term. The interest rate that you lock in is a product of a wide range of factors, including but not limited to the length of your term, your credit history, the type of loan servicer with whom you’re working, the size of your down payment and the price of your home.
Fixed-rate mortgages come in a variety of term lengths, but the most common by far are 15-year and 30-year mortgages. Each of these have pros and cons. You’ll have the benefit of a lower monthly payment with a longer term, but thanks to the interest, you’ll end up paying significantly more over the entire course of the term.
Seeing as fixed-rate loans provide you with the security of stability, it’s only natural that said stability comes at a price. Namely, the interest rate you’ll receive with a fixed-rate mortgage will almost surely be higher than what you’d start out paying with a comparable ARM.
When interest rates across the financial markets are elevated, fixed-rate mortgages become a bit more difficult to qualify for. This is because a higher interest rate means a higher monthly payment, and a higher monthly payment means a larger burden of proof on the applicant to demonstrate that the payment is within their means. This needn’t be a big factor in your decision, however, as it will influence adjustable-rate loans as well.
An adjustable-rate mortgage, sometimes referred to as a variable-rate mortgage or a floating-rate mortgage, can be thought of as a loan in two parts. The first part looks like a fixed-rate mortgage. You’ll know exactly what your interest rate will be for a fixed period of time, the length of which can vary (more on that below).
Once that fixed period concludes, your interest rate will “adjust” according to some agreed upon benchmark, likely a percentage called the London Interbank Offered Rate (LIBOR). That means that your monthly payment could be higher or lower than what you were paying in the introductory period. If interest rates in the market have increased since you first got your loan, then you’ll have to pony up more each month.
There are two factors that will influence how much the variable interest rate adjusts: the ARM index and the ARM margin. The ARM index is almost always an external benchmark rate of some kind. It could be LIBOR like mentioned above, but it could also be the current rate of U.S. Treasury notes or the prime rate. The ARM margin is a constant amount of interest that your mortgage lender will apply *in addition* to the ARM index. So if the LIBOR is 4.5% and your ARM margin is 2.5%, then your mortgage interest rate would be 7%.
When it comes to the length of each period of your loan, there are a wide range of options. One common structure is a fixed, introductory period that last for five years, then a variable period during which the interest rates adjusts on an annual basis for the duration of the loan term. We’d refer to this structure as a 5/1 ARM, signifying the 5-year fixed period and the adjustments that happen every 1 year following.
Who Should Get a Fixed-Rate Mortgage?
If you are torn between the two types of mortgages, you may want to ask yourself how the decision would differ in a worst-case scenario. If interest rates were to take a sharp hike, much like what’s currently happening at the time of this article’s publication, would you still be able to comfortably afford monthly payments with an ARM that’s subject to those hikes? If the answer is no, you might be better off with the peace of mind that comes from a fixed-rate loan.
If you intend to live in the home for decades and you’re buying during a period of relatively low interest rates, a fixed-rate loan could make a lot of sense. Locking in that low rate could pay off if you don’t expect the rates to last.
Who Should Get an Adjustable-Rate Mortgage?
The primary group of people who may benefit from an ARM are buyers who don’t expect to continue with their mortgage for the duration of the term. This could be buyers who know that they’ll refinance their loan at some point down the line, or it could be buyers who know that they’ll be selling the property before the mortgage is up.
The former group, the refinancers, are often betting that interest rates will have fallen in the future when they’re looking to restructure their terms. If you purchase a fixed-rate loan and then interest rates fall, you end up paying more each month than the market would dictate in the present day.
For the latter group, the short-term owners, it makes perfect sense to take the option that provides lower interest rates to start. The fixed period of an ARM can be as short as one year and sometimes as long as seven years, so if you don’t expect to live in your home for longer than that, you could save a lot in interest payments by avoiding the fixed-rate option.
A less common situation is if a buyer expects that she’ll have most or all the money necessary to pay the mortgage off in full some time in the future before the fixed period of the loan ends. An example could be if the buyer expects to come into money from investments, inheritance or the future sale of a different property.
Ultimately, there are a wide variety of mortgages available because there’s an even wider variety of homebuyers, each with a distinct amalgamation of resources at their disposal and needs to satisfy. Making the choice between a fixed rate or a variable one can help you take one step forward in your home buying journey, bringing you closer to the goal of building wealth and the financial life you want.
Tips to Buy a Home
- A financial advisor can help you create a financial plan to set and reach your home buying goals. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to buy a home, it’s a smart idea to know how much of a home you can afford. SmartAsset’s free calculator can help you get an estimate.
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