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- When you get a mortgage, your rate can either be fixed or adjustable.
- A fixed rate stays the same for the life of the loan, while an adjustable rate can change periodically.
- Fixed rates are popular for their predictability. ARMs have more risk, but they can also come with lower rates.
When you get a mortgage, you'll need to make a lot of different decisions: whether you want a conventional or government-backed loan, the length of the loan term, and whether you want a rate that is fixed or adjustable.
The question of fixed- vs. adjustable-rate mortgage is an important one, because it determines the range of interest rates available to you, how much you'll pay overall to get the mortgage, and whether your monthly mortgage payment could change down the road.
Not sure whether a fixed-rate mortgage or an adjustable-rate mortgage is right for you? There are a few factors you'll need to consider.
Understanding adjustable-rate mortgages (ARMs)
Adjustable-rate mortgages may not be the most popular type of mortgage out there, but they can be useful for certain homebuyers. Here's what to know about these loans.
What is an adjustable-rate mortgage?
An adjustable-rate mortgage, often called an ARM, is a mortgage in which the interest rate can change — or adjust — over time. This means your payment can change, too.
This is different from a fixed-rate loan, which has a consistent rate for the entire loan term.
How ARMs work
With ARMs, your interest rate (and mortgage payment) will remain the same for a set period of time at the beginning of the loan, and then change periodically. For example, a 5/1 ARM locks in your rate for the first five years, and then your rate will adjust once a year, moving up or down depending on rate trends in the U.S.
Key features of ARMs
ARMs come with rules that determine your current rate, how much your rate can change each time it adjusts, and how much it can go up overall.
Your ARM rate will be based on two factors: The index and the margin.
- Index: This is the benchmark rate that a lender bases their ARM rates on. Different lenders use different indexes, such as the U.S. prime rate. Your rate can go up or down based on how the index trends.
- Margin: This is the amount of interest the lender adds to the index to make up your total interest rate. While the index rate can change throughout the life of your loan, the margin amount stays the same.
For example, if the index rate is currently 4.5% and your margin is 2%, your total interest rate would be 6.5%.
ARMs also come with rate caps that limit how much your rate can increase or decrease. Typically, your loan will have a limit on how much it can change on the initial adjustment and on each subsequent adjustment. It will also have a minimum and maximum rate that applies for the entire life of the loan.
Understanding fixed-rate mortgages
Fixed-rate mortgages are a much more popular loan option, as they offer consistency and stability. Most homebuyers choose these, since they are easy to budget and plan for.
What is a fixed-rate mortgage?
A fixed-rate mortgage is a mortgage loan in which the interest rate is set in stone. The rate you have at closing won't change or adjust at any point throughout your loan term.
How fixed-rate mortgages work
With a fixed-rate mortgage, your interest rate remains the same for the entire life of the loan. If you have a 30-year fixed-rate mortgage, you'll pay the same rate today as you will 30 years from now.
Key features of fixed-rate mortgages
When you have a fixed-rate mortgage, your monthly mortgage payment stays relatively predictable. Though your overall payment can go up if your property taxes or insurance increase, your principal and interest amount won't change. This stability is what makes fixed-rate mortgages the most popular type of mortgage.
But to pay for that stability, fixed-rate mortgages often have higher rates than ARMs — at least at the start of the loan. Once ARMs start to adjust, their rates may end up higher than those on a fixed-rate mortgage.
Pros and cons of adjustable-rate mortgages
Adjustable-rate mortgages aren't for everyone, but they can be right in some scenarios. Here are the pros and cons to consider before you take out an ARM.
Pros of ARMs
The main benefit of an ARM is that you could get a lower initial rate. Initial ARM rates are often (but not always) lower than fixed rates. So if you plan to move or refinance before the initial rate period ends, you could benefit from a lower ARM rate.
A lower rate also means more budget flexibility. When you're paying less interest on your monthly mortgage payment, you can use that money toward other financial goals, such as paying down debt or contributing to your retirement fund.
Finally, if rates decrease later, you could get a lower rate and monthly payment. Depending on what happens with the economy, your ARM's rate could actually decrease once your initial rate period is up.
Cons of ARMs
ARMs are risky because they could end up straining your budget. And even though you might plan to move or refinance before your rate resets, it's hard to know for sure that it'll be possible for you to do so.
When choosing your ARM's fixed-term length, John P. Roland, partner and private wealth advisor with Beyond Financial Advisors, recommends leaving yourself some wiggle room in case something doesn't go according to plan.
"So for example, if you're buying your first home and you know it's a starter home and you intend to be there for five years or so, consider having a seven-year ARM," he says.
You should also check the loan estimate provided by your lender to find out how much your rate could ultimately increase, and what your highest possible monthly payment would look like. When considering your housing budget, think about how that number fits in.
Pros and cons of fixed-rate mortgages
There's a reason most homebuyers choose fixed-rate loans, but that doesn't mean they're for everyone. Weigh these pros and cons before choosing one of these mortgages.
Pros of fixed-rate mortgages
The biggest advantage of fixed-rate mortgages is that they have a predictable rate and payment, making them easy to budget for. Granted, certain payments that are wrapped up in your mortgage could change over the years, such as homeowners insurance or property taxes. But your interest rate will stay the same from year to year, which could make it easier for you to plan out your monthly expenses.
Also, if mortgage rates increase, you'll keep your lower rate. In this scenario, your rate would increase if you chose an ARM. But with a fixed rate, you get to keep your rate for the entire life of your loan.
Cons of fixed-rate mortgages
The only real drawback to a fixed-rate loan is that you may get a slightly higher interest rate than an ARM initially offers. Keep in mind that once the ARM rate adjusts, however, this may no longer be the case.
Comparing adjustable-rate mortgages vs. fixed-rate mortgages
Both adjustable-rate and fixed-rate mortgages can be a good choice in the right situation. Here's how the two compare side by side.
Cost differences
ARMs usually have lower rates up front, but those rates can move up or down over time, so it doesn't necessarily mean the loan will cost less over time. Fixed-rate mortgages have the same rate the entire loan term.
Closing costs and fees are the same on these loans, though the exact cost will depend on your loan amount and lender.
Risk factors
ARMs are definitely the riskier choice, as they come with rates and payments that can change over time. If the rate or payment goes too high, you might have trouble paying, which could lead to foreclosure.
Fixed-rate mortgages are a fairly safe option to use. While your home is still the collateral, you can count on your rate and payment being the same as when you initially got approved for the loan.
Long-term financial planning
A fixed-rate loan is better for long-term financial planning, since you'll always know what rate and payment you'll be making. You can then make plans for any residual cash you have and achieve other financial goals.
ARMs can make it hard to plan long term. You'll want to have a solid savings account in place in case your payment rises and your income no longer covers it.
Market conditions
Market conditions play a big role in whether an ARM is a good move or not. If market rates fall, an ARM could be great, as your rate and payment would fall, too. If the opposite happens, it could be a huge financial strain. Unfortunately, predicting which way the market will go — especially years down the line — isn't really possible.
Which mortgage is right for you?
Not sure whether an ARM or fixed-rate mortgage is best for your needs Here's what to think about.
Factors to consider
You should think about your budget and income, and what sort of payment fits into those. If your income is unpredictable, throwing in a rate and payment that is also unpredictable probably isn't wise. However, if you have steady income and plenty of cash to handle a potential increase, then an ARM might be a good option.
Personal financial goals
What are your financial goals? Do you want to pay off the loan quickly with the least possible interest? Get the lowest payment now, as you get used to homeownership, and then deal with higher payments later on? Do you want to be able to take advantage of market fluctuations if rates fall? Understand what your long-term financial hopes are, and choose the loan that aligns with those best.
Time horizon and future plans
Finally, think about your plans for the home. Do you want to stay there for the long haul? If so, a fixed-rate loan may be best, as it offers long-term stability. If you plan to move soon or are OK with refinancing in a few years, an ARM may be the better option.
FAQs on adjustable-rate mortgages vs. fixed-rate mortgages
ARMs have variable interest rates that can change over time, while fixed-rate mortgages have a constant rate for the whole loan term.
ARMs are generally riskier due to potential rate increases, whereas fixed-rate mortgages offer stability.
ARMs are suitable if you plan to move or refinance before the adjustable period begins.
That depends on your goals, budget, and long-term plans as a homeowner. If you plan to move or refinance in a few years, an adjustable-rate loan could be smart. If you want to live there for the long haul, though, a fixed-rate mortgage is usually best.
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