Get the Facts About Fixed-Rate and Adjustable-Rate Mortgages

Buying a home is a big, exciting step. It involves making lots of decisions, including which type of mortgage is the best fit for your current situation and financial goals. Fixed-rate mortgages and adjustable-rate mortgages (ARMs) are two popular choices we see homebuyers go with. In this article, we’ll explain the key differences between fixed-rate and adjustable-rate mortgages and take a closer look at how adjustable-rate mortgages work.

Fixed-Rate Mortgage

By far the most popular type of mortgage in the United States is a 30-year fixed-rate mortgage, which means the term of the loan is 30 years and the interest rate is fixed – or stays the same – for all 30 years. Approximately 90% of home buyers choose a fixed mortgage. While a 30-year term is the most common, a 15-year fixed-rate mortgage is also a good choice for some. 

A lot of home buyers decide to go with fixed-rate mortgages because it makes it easier to anticipate and budget for monthly expenses. A quick note, if you do go with a fixed-rate mortgage, property taxes and insurance premiums can still change, impacting your total housing costs.

Adjustable-Rate Mortgage

Now let’s take a closer look at how an adjustable-rate mortgage works. The term of an ARM is in two parts: 

• Fixed-rate period. With an adjustable-rate mortgage, the interest rate you pay as a homeowner is fixed for a number of years at the beginning of the term of the loan. Fixed-rate periods are generally three, five, seven, or 10 years.
• Adjustment period. Then, the interest rate adjusts – usually every 12 months – after the fixed-rate period ends.

Let’s look at an example: say you have a 30-year ARM with a five-year fixed-rate period. This means your rate would not change for the first five years of the loan. After that, your rate could go up or down for the remaining 25 years of the loan.

Adjustable-rate mortgages usually start with a lower interest rate than fixed-rate mortgages, which can make them attractive to borrowers who are looking for a lower initial monthly payment. 

That low rate may change after the initial fixed-rate period, however, causing your payments to fluctuate. But payment caps limit how much your mortgage rate and monthly payment can increase. These include:

• Initial adjustment cap. This limits the amount the interest rate can go up the first time the payment adjusts.
• Subsequent adjustment cap. This limits rate increases after the first adjustment.
• Lifetime adjustment cap. This is a limit on total rate increases for the life of the loan. For example, regardless of market conditions, the rate can’t increase more than 5% over the loan term.

Adjustable-Rate Mortgage Pros and Cons

Choosing an ARM can offer several benefits, but it’s also important to understand the potential drawbacks.

Pros

• Low payments during the fixed-rate phase. Your introductory interest rate is locked in before it can change, which gives you predictable low payments.
• Flexibility. If you know you plan to sell the home or pay off the mortgage before the fixed-rate period ends, an ARM could be a good choice.
• Your payments may go down. If interest rates drop, your monthly payment during the adjustment period could also decrease.

Cons

• Your payment may go up. If interest rates rise, your payments could increase after the adjustment period starts.
  
• Prepayment penalty. Some mortgages include a prepayment penalty, so be sure to review your loan terms before deciding to sell, refinance, or pay off the loan early.
• ARMs can be complicated. Adjustable-rate mortgages are more complex than fixed-rate mortgages, so be sure to understand the rules and fees so you can make the best decision.

Why Choose an Adjustable-Rate Mortgage?

Adjustable-rate mortgages can make sense in the following scenarios:

• The potential for a future move or relocation. An ARM can be a great choice if you plan to relocate before the fixed-rate period ends. For example, if you have a job that transfers you around a lot, an ARM might be a viable option.
• Potential changes in financial circumstances. Your rate and monthly payment may be lower at first, allowing you to align the adjustment period with an expected income increase. For example, a recent medical school graduate paying down student loans may benefit from lower initial mortgage payments. By the time the fixed-rate period ends, their income may be higher, making potential rate changes more manageable. 

While fixed-rate mortgages are generally more predictable, an adjustable-rate loan can be a good fit for homeowners who expect to move or sell in a few years. You’ll want to weigh your options carefully and choose the type of mortgage that makes the most sense for your individual situation. If you need help with planning your finances or have questions about getting a mortgage, reach out to one of our mortgage loan officers.