Fixed Rate Mortgages vs. Adjustable Rate Mortgages
When a borrower applies for a mortgage loan, there are many loan options to consider. However, for most people, they will choose either a Fixed Rate Mortgage or an Adjustable Rate Mortgage from their lender. Since these two loan types are the most common, it is important to know the value of each and to understand how they differ.
Fixed Rate Mortgage Loans
Fixed rate mortgages are the most popular form of loans for buying a home or refinancing an existing mortgage. These loans offer borrowers the security of regular, stable and affordable monthly payments, and protection from fluctuations in the market.
As their name implies, these kinds of mortgages feature an interest rate that stays the same over the life of the loan – the interest rate is “fixed.” Because the rate
is not subject to change – no matter how high interest rates might rise in the future – borrowers have the security of knowing that their payment will be the same every month through the entire term of their loan.
Borrowers appreciate the stability that comes with a fixed rate mortgage because it allows them to plan their finances accordingly. In addition, they also welcome these other fixed rate advantages:
- Loan terms are straightforward and easy to understand
- The security of a fixed rate loan is attractive to many borrowers, due to consistent monthly payments with no surprises
- Borrowers can choose how quickly to pay off their mortgage
Once a borrower determines which type of loan to select, they will also have to choose a term, meaning how many years it will take to pay off the loan. The most common terms are 15-year and 30-year mortgages, but shorter and longer terms are also available.
In some areas of the country where high-priced housing is common, some lenders offer 40-year and 50-year mortgages because the average family cannot afford to buy a home with a standard 30-year term.
Let’s take a brief look at the differences between a 15-year and 30-year fixed-rate mortgage terms:
One of the primary benefits of the 15-year fixed rate term is that it allows you to repay your mortgage in half the time of a 30-year term. The shorter term means you will:
- Have a lower interest rate than a 30-year fixed
- Pay less interest over the life of the loan since the loan is being paid off faster
- Build equity faster than in a 30-year fixed mortgage
- The 15-year fixed is ideal for move-up buyers or for refinancing a current mortgage
The 30-year fixed rate term offers the security of a fixed interest rate, plus an affordable payment. 30-year fixed rate loans offer:
- Even more affordable payments than 15-year fixed loans
- Security of consistent payments
- Protection from inflation
- The 30-year fixed is ideal for first-time buyers due to the lower, more affordable payments
Once a decision has been made about the type of loan and the loan term, there are several additional steps a borrower should take in order to secure a fixed rate mortgage.
The first step is to become pre-approved for a mortgage loan. Having a credit pre-approval can:
- Save time shopping for properties in a suitable price range
- Create credibility with sellers by letting them know you're qualified and serious
- Speed up the closing process and get your loan funded sooner
- Improve your experience in the home buying process
In addition, the lender will request additional financial documentation such as:
- Homeowner's Insurance
- Proof of Income
- Asset Information
Adjustable Rate Mortgages
An Adjustable Rate Mortgage, or ARM, is a variable rate mortgage. Unlike a fixed rate mortgage, the interest rate charged on an outstanding loan balance “varies” as market interest rates change. As a result, mortgage payments will vary as well.
Typically, an ARM has a fixed interest rate for a specified period of time at the beginning of the loan, usually 5 or 7 years. After that initial period has passed, the fixed interest rate transitions to a variable interest rate, meaning the interest rate will vary depending on what’s happening in the market at that time.
Interest rates could go up or they could go down. The risk of what’s happening in the market has shifted from the lender to the borrower with an adjustable rate mortgage. But borrowers should be aware that there are “caps” on an adjustable rate mortgage, meaning their variable interest rate cannot go beyond a certain point.
Because the borrower is assuming more risk with an ARM, the initial interest rates and payments are lower than fixed-rate mortgages. Many borrowers choose an ARM option as they offer greater savings up front.
With initial interest rates and payments that are lower than fixed rate loans, ARM loans offer what many borrowers need:
- Upfront savings – with a lower rate and payment in the initial period, borrowers are saving more money compared to a fixed rate mortgage.
- Initial fixed period – borrowers appreciate the lower fixed rate for the initial period
- Cap on the amount of the interest rate – borrowers won’t be taken completely by surprise because there are limits on the adjustment
In addition, adjustable rate mortgages benefit borrowers who:
- Move frequently
- Expect to earn more in a few years
- Purchase, renovate and resell properties
- Plan to refinance before the loan adjusts
- Have growing families and might need a larger home in the future
In addition, a typical ARM loan has a limit of $424,100 but it can be higher than that amount, depending on the region. Also, down payments for ARMs are usually the same as fixed rate mortgages, but there are some ARM types that allow for lower down payments. And finally, there are down payment assistance resources available to those who qualify for help.
Fixed-Rate Mortgages vs. Adjustable-Rate Mortgages
Both fixed-rate mortgages and adjustable-rate mortgages have their advantages, but some studies have found that, over time, a borrower is likely to pay less interest overall with an adjustable-rate loan versus a fixed-rate loan.
But it’s important to note that the borrower must be aware of specific circumstances in the market before making a decision.
Generally speaking, if interest rates are trending low, it might be more advantageous to acquire an adjustable rate mortgage to take advantage of lower interest rates. However, if interest rates are on the rise, it might be better to obtain a fixed rate mortgage to avoid uncertain spikes in interest rates.
Whatever the circumstances are when applying for a mortgage loan, make sure you discuss the subject in detail with a qualified lending officer or a financial adviser. Also, make sure you check out this year's best rated mortgage providers.