There are so many decisions to be made when buying a home, and the type of mortgage to take out is one of the more important ones. With all the different mortgage products and variations out there, it can be daunting to choose a specific type of mortgage that will help you finance a home purchase while making it easy for you to comfortably make your mortgage payments every month.
Among all the different factors associated with mortgages that borrowers must decide on is fixed rates versus adjustable rates. While one stays the same through the mortgage term, the other fluctuates. One might sound better than the other at face value, but depending on the market and your current financial situation, one might end up being more convenient and even more affordable for you.
So, which one is better: fixed-rate or adjustable-rate mortgages?
What is a Fixed-Rate Mortgage?
A fixed-rate mortgage comes with an interest rate that remains steady throughout the life of the mortgage. During this time period, it never changes, and as such, the mortgage payment never changes, either.
The only things about the mortgage payment that will change from one month to the next are the portions allocated to the principal and the interest. With each payment made, a little bit of the principal is paid down, which reduces the overall loan amount and therefore the amount of interest charged. However, the total payment stays the same.
Many borrowers like the idea of having steady payments, making them more predictable and easier to budget for. Fixed-rate loans are also ideal when interest rates are expected in increase in the near future. In this case, locking in at today’s interest rate with a fixed-rate mortgage protects the borrower from being vulnerable to higher rates should they increase throughout the life of the loan.
While the interest rate may be fixed, the total interest amount that the borrower pays will depend on the length of the mortgage term.
What is an Adjustable-Rate Mortgage?
Whereas fixed-rate mortgages come with interest rates that do not change over the life of the loan, adjustable-rate mortgage (ARM) interest rates do fluctuate from time to time.
These types of mortgages attract borrowers because their advertised rates are usually lower than those of fixed-rate mortgages. These lower rates are usually offered during an initial introductory period, after which the rate often increases.
When the initial introductory period expires, the rate adjusts at a frequency that has been pre-determined. This fixed-rate period can vary from anywhere between a month to as long as 10 years.
That said, shorter adjustment periods typically come with lower interest rates at the onset. Once this initial term is over, the mortgage resets. At this point, a new interest rate is put in place that’s based on current market conditions. Until the rate is reset again, the interest rate on the mortgage will remain the same.
ARMs are written as ratios that dictate how long the interest rate will remain fixed and how frequently after that the rate will change. For instance, a “5/1” ARM is quite popular, which basically means the interest rate will stay fixed for five years and will be adjusted – along with your payments – every year going forward.
It’s certainly possible for the rate to increase at some point throughout the life of the loan, and even surpass the rates associated with fixed-rate mortgages. Adjustable-rate mortgages are better suited in an environment where the rates are expected to decrease in the near future, helping borrowers save money over the long run.
Which is Better: Fixed-Rate or Adjustable-Rate Mortgages?
The answer to this question depends on the current market and your particular situation and comfort zone. Generally speaking, a fixed-rate mortgage might be better suited for borrowers who like the idea of having predictable payments that will not change over the life of the loan.
They make budgeting much easier, especially when there isn’t a lot of wiggle room with finances. Anyone with a low tolerance for risk might appreciate the predictability of fixed-rate mortgages.
Further, fixed-rate mortgages might make more sense if the rates are expected to increase in the near future. In this case, locking in a today’s rate can protect against any increase in rates that are anticipated. This can help save borrowers tens of thousands of dollars over the life of the loan.
Adjustable-rate mortgages, on the other hand, might be better suited in a market where rates are expected to decrease in the near future or remain steady. In this case, borrowers can take advantage of the lower introductory rate compared to fixed-rate mortgages.
Even if rates might increase in the future, adjustable-rate mortgages might still be a great option for those who don’t plan on staying in their home for very long. A buyer who plans to sell their home before the introductory period expires could be saving quite a bit of money, even if rates rise after that introductory period is over.
The Bottom Line
Both fixed-rate and adjustable-rate mortgages can offer borrowers specific advantages. Depending on factors such as the temperature of the market, a borrower’s tolerance for risk, and a borrower’s plans for selling in the near future, the decision could go either way. Speak with a seasoned mortgage broker to help you determine loan product is better suited for you.