The home mortgage process usually begins by narrowing down the best home loan for your needs. Depending on your situation, choosing either a fixed rate or an adjustable rate mortgage (ARM) can reduce the cost of homeownership and accelerate the time it takes to own the home free-and-clear. In order to make the right choice, you need to understand how each of these loans work — in addition to their pros and cons. And that’s exactly what we will discuss in this article.
Here’s the most important difference between the two loans:
- A fixed rate loan has an interest rate that will not change throughout the life of the loan
- An adjustable rate loan has an interest rate that can change, multiple times, throughout the life of the loan
Check out our Best Picks for Fixed Rate Loans
Fixed Rate Loans
With an interest rate that does not change, fixed rate loans allow you to enjoy stable monthly mortgage payments throughout the life of the loan. There are variety of fixed rate loans available, and all feature the same benefits:
- Predictable monthly payments help make it easier to manage and maintain a household budget
- With a “fixed” interest rate, you’re protected against bad economic times, inflation, and interest rate increases (today’s rates can’t stay low forever)
- They’re available in a very wide variety of loan types, including conventional, jumbo, and government-backed FHA, VA, USDA and other loan programs
30-year and 15-year fixed rate loans are the most common fixed rate loans.
30-year Fixed Rate Loan:
- Features low monthly payments because they’re spread over a longer period of time
- More is paid toward interest over the life of the loan because there are more payments
- A great loan if you plan to stay in your home a long time and want to maintain low monthly payments
15-year Fixed Rate loan:
- Features slightly higher monthly mortgage payments because you have to pay the loan off sooner
- Features a lower interest rate than a 30-year fixed rate loan
- Saves you thousands of dollars in interest payments over the life of the loan
- With a shorter term, the loan is paid off much sooner
One disadvantage to a fixed rate loan is if the rates drop, you’re stuck with that rate. But as low as they are today, getting a fixed rate loan to buy or refinance a home isn’t much of a risk at all. In fact, it’s a good bet.
Adjustable Rate Loans (ARM)
ARMs have an interest rate that will vary, or adjust, over the life of the loan. They begin with an introductory period during which the rate does not change and that is actually lower than a fixed rate mortgage. Typically, this period ranges from one to ten years. After this time, the rate can change. It will go up or down to reflect or match where the current market rates are overall. If you get an ARM with rates where they are today, you’d have a mortgage with an extremely low interest rate and monthly payments. But if, or when, they go up before your rate is scheduled to adjust, you could experience a dramatic increase in your monthly payments. It’s a very good loan if you use it for the right reasons.
The most common types of adjustable rate mortgages are the 3/1 ARM, 5/1 ARM, 7/1 ARM, 10/1 ARM and the standard ARM.
The first number represents the introductory period when the interest rate is fixed and will not change. Afterwards, the rate can change once every year for the remaining term of the loan. For a 5/1 ARM, the interest rate stays the same for the first five years, and can then change every year for the remainder of the loan. A standard ARM has an initial fixed rate period of six months to a year.
When the rate on an ARM changes, it’s only applied to the remaining years and balance on the loan, not the original terms – so there are some savings to be captured there. There are also caps, or limits, to how high or low the rate can adjust each year, as well as over the life of the loan.
Benefits to getting an ARM:
- It’s a great loan for people who know they’ll move before the rate changes
- You can get some of the lowest interest rates and monthly payments possible
- Lower payments could allow you to afford a larger house or live in a nicer neighborhood
- The money you save with low monthly payments can be invested or used for other purposes
- They’re also available in a wide variety of conventional and government-backed loans
Important considerations before getting an ARM:
- It’s essential that you clearly understand how your loan will work
- Know what the limits on rate increases/decreases are each year, over the life of the loan, and the dates they adjust
- Plan ahead for the rate adjustment – if you don’t sell the home before then, consider refinancing if the new rate will increase your monthly payments
- Keep in mind, if your property value goes down, or your income drops due to a job loss or other event, refinancing might not become an option
- You should calculate, in a worse-case scenario, if you’ll be able afford the maximum rate and payment increases in the loan
Check out our Best Picks for Adjustable Rate Mortgages here
So, Which Loan Type is Right for Me?
Let’s recap: a fixed rate loan maintains the same interest rate and payments over an extended period of time. An ARM loan maintains its interest rate for a small period, then adjusts annually. The risk of an ARM as opposed to the consistency of a fixed rate loan can make the choice seem easy to make, but consider the following:
- Are you staying in your home long-term?If you’re planning to move within a few years, a lower-rate ARM may be right for you. They can be more affordable if you get a reasonable lower monthly payment and rate. The extra leftover cash will allow you to build savings for your future home. You’ll also won’t be exposed to fluctuating rate adjustments if you choose an ARM that suits your plans. Remember: a fixed rate loan is, ultimately, a long-term commitment.
- How frequently will your ARM adjust, and when will it be made?After the initial fixed-period, your ARM will likely adjust every year on the anniversary of the mortgage. The new rate will be set days beforehand, based on the index your lender provides, but some can adjust monthly. If the monthly fluctuation is too much for you to budget around, we recommend a fixed rate mortgage.
- What is the interest rate like in your area? When the local interest rates are high, it makes the most sense to choose an ARM loan, because they allow lower initial rates while allowing borrowers to become homeowners. Fixed rate mortgages make the most sense when you plan on buying long-term in your area and want to have your interest rates stay low.
- If interest rates are high, could you still afford your monthly payment? It’s always a good idea to give yourself leeway when paying bills: especially when dealing with home payments. When looking into an ARM, be sure to calculate how much of a monthly payment you can reasonably afford if your rates were to rise over time. If you’re uncertain you can reasonably pay your monthly payments with a higher interest rate, it might be worth looking into a fixed rate mortgage loan.