Mortgages come in two types: fixed-rate and adjustable-rate. When buying or refinancing a home, understanding the pros and cons of fixed and variable rate mortgages is critical.
In this article will cover how these two types of mortgages work. We’ll also look at the pros and cons of each. The goal is to help you pick the best type of mortgage for your specific situations.
A fixed-rate mortgage is exactly what its name suggests. The interest rate for a fixed-rate mortgage remains constant throughout the life of the mortgage. In a 4% fixed-rate 30-year mortgage, for example, the interest remains 4% for the entire 30 years. The rate doesn’t change even if current rates rise significantly.
A fixed-rate mortgage enables you to budget your monthly expenses for up to 30 years without worrying about your rate suddenly spiking. It is also easy to understand for first-time buyers.
Pros of a Fixed-Rate Mortgage
A fixed-rate mortgage has several advantages:
- Stability: The rate never changes, so your principal and interest payment stays the same
- Budgeting: The stability in your monthly payment makes budgeting easier
- Peace of Mind: There’s no reason to worry that rising interest rates could increase your monthly payment
Cons of a Fixed-Rate Mortgage
There is one significant disadvantage to fixed-rate mortgages. The interest rate typically is higher than the initial rate on a variable-rate mortgage. We’ll look at an example in a moment.
The bottom line on fixed-rate mortgages is that they are the safe, steady option ideal for many buyers.
An adjustable-rate mortgage (also known as an ARM) differs from a fixed-rate mortgage in several ways. First, and most obvious, the interest rate can change over time. Second, and less obvious, is that the way the rate can change varies from one ARM to the next.
An ARM typically has some period of time during which the rate is fixed. After this initial period, the rate adjusts based on a formula typically tied to some economic indicator. Depending on the terms of the loan, the rate can continue to adjust up or down thereafter.
When shopping for an adjustable-rate mortgage, you must consider several factors:
- How the adjustable-rate is set
- When the rate can adjust the first time
- How often the bank can adjust the rate thereafter
- How much the bank can adjust the rate the first time (called an Initial Cap)
- How much the bank can adjust the rate thereafter (called a Periodic Cap)
- The highest (and lowest) the rate can go (called a Lifetime Cap)
The best way to understand these types of mortgages is with an example. A common adjustable-rate mortgage is called a 5/1 ARM. This means that the initial rate is fixed for five years. The rate then adjusts each year thereafter for the life of the mortgage.
A similar example is a 7/1 ARM. In this case, the initial rate is fixed for seven years instead of five.
There are more complicated adjustable-rate mortgages. For example, the rate is often expressed as something like 2/2/5. These numbers are important to understand:
- The first 2: This is the Initial Cap. After the initial fixed-rate period expires, the rate can increase, at most, by 2%.
- The second 2: The Periodic Cap. All future rate adjustments can go up by no more than 2%. Note: The Initial Cap and the Periodic Cap are not always the same.
- The 5: This is the Lifetime Cap. Fora loan that starts at 3%, for example, the highest the rate can go over the life of the loan is 8% (3 + 5).
Pros of ARMs
- Initial Rate: The initial interest rate is typically lower than a fixed-rate mortgage.
- Rate Changes: The interest rate could, in theory, go down of the index used to set the rate is lower.
Cons of ARMs
- Complicated: As you can see from the examples above, an adjustable-rate mortgage has a lot of moving parts
- Risky: The interest rates could rise significantly over time.
How to Decide
Deciding between a fixed-rate and adjustable-rate mortgage is not an exact science. There are, however, several questions you should consider:
- How long do you plan to live in the home? For those who plan to stay in the home more than a few years, a fixed-rate mortgage is often a better option. In contrast, if you plan to stay in the home for fewer than 5 years, a 5/1 ARM may be ideal.
- How important is it to have a set monthly budget? If you have little room for extra expenses, an ARM may be the wrong choice.
- Do you think rates are more likely to rise or fall? This is a bit of a guessing game. With rates at historic lows, however, it seems more likely that they will rise. Rising rates make fixed-rate mortgages more attractive.
We Prefer Fixed-Rate Mortgages
As you can tell, we generally favor fixed-rate mortgages. The fact that mortgage rates continue to slide means that fixed-rate mortgages are more competitive than ever when compared to variable-rate options. But that doesn’t mean that a fixed-rate loan is best in all cases.
Variable-rate mortgages got a pretty bad reputation following the big financial crisis of 2008. While it’s true that variable-rate mortgages should be handled carefully, they shouldn’t automatically be off the table if you’re about to purchase a home. In fact, these loans are making a comeback nearly a decade after they received villain status.
ARMs Work in Some Cases
A variable-rate loan offers lower rates and payments during the introductory period of a loan term. This allows people to buy larger homes than they might be able to with a fixed-rate loan. This loan type could save you a lot of money if you plan to stay in the home for a short amount of time. You’ll usually come out ahead with a variable-rate loan if you relocate to another area or you move to a larger home before the loan’s introductory period ends.
It’s important not to skip over the fact that the potential pitfalls of this type of loan are pretty large. Your monthly payments could increase very sharply if interest rates see a big spike. This is something you have no control over. Variable-rate loans are also complicated. This is why first-time buyers should probably stay away from this option unless they have a pretty solid understanding of how mortgages and financing work.
Here are the questions to ask when considering a variable-rate mortgage:
- Am I confident that I cna maintain my monthly payments if my interest rate suddenly increases?
- Am I purchasing a home for the sake of selling it at a profit once I move within five years?
- Is my main goal to save up a down payment for a better home while making lower initial payments on a smaller home?
Regardless of your choice, you can get multiple rate quotes online for free at LendingTree.
Published or updated September 11, 2017.