When purchasing and financing a home, one of the biggest decisions you’ll be faced with is choosing which loan type to use to finance your new home. While there are many different loan types to choose from, fixed-rate mortgages and adjustable-rate mortgages (ARMs) are the two primary mortgage types. Both types have their own pros and cons, so choosing between the two can be tricky. To aid you in your decision, we’ve covered the main differences between a fixed-rate mortgage and an adjustable-rate mortgage, and which option may be right for you.
Fixed-rate mortgages are mortgage loans that have a fixed interest rate for the entire term of the loan. Generally, these loans are offered as amortized loans, which means that the loan has scheduled periodic payments that are applied to both principal and interest. Though amortized loans are a popular choice, fixed-rate mortgage loans work with non-amortized loans as well.
One of the main advantages of a fixed-rate mortgage is that the rate is fixed, protecting you from increases in your monthly payments if interest rates rise. The predictability and stability these loans offer also help with budgeting since your payments remain the same each month.
The downside of fixed-rate mortgages is that when rates are rising, it can be difficult to qualify for a loan because loan payments can become less affordable. Before applying for a loan, be sure to estimate your monthly payments so you have a good idea of what you can expect to pay each month.
Adjustable Rate Mortgages (ARMs)
Adjustable-rate mortgages are a type of mortgage whose interest rate varies throughout the life of the loan. Generally, the initial interest rate is fixed for a period of time, then resets depending on the terms of the loan.
Adjustable-rate mortgages are expressed as two numbers, with the top number indicating the length of time the fixed rate is applied, and the second number typically indicating the length of time the rate adjusts. For example, a 5/1 ARM has a fixed rate for five years, which is followed by a variable rate that adjusts every year. Keep in mind, the second number doesn’t always indicate years. The 5/6 ARM has a fixed rate for five years and then adjusts every six months.
After the fixed-rate period, the interest rate can increase or decrease based on an index and a set margin, which are added together. The index is a benchmark interest rate that reflects general market conditions and the margin is a number set by your lender when you apply for your loan. Adjustable-rate mortgages also typically have rate caps that can limit how high the rate can be, and how drastically the payments can change.
Adjustable-rate mortgages can be risky if you’re not prepared. Before taking out an ARM loan, be sure to find out:
- How much your interest rate and payment can increase with each adjustment.
- If the loan has a rate cap on how high the interest rate can go, and a limit on how low the rate can go.
- How frequently your interest rate will adjust so you can be prepared for increased payments, if necessary.
ARM or Fixed-Rate: Which Option is Best for You?
Now that you know the main differences between a fixed-rate and an adjustable-rate mortgage, you should have an easier time determining which option is best for you. A few things to keep in mind as you’re making the decision:
- How long do you plan to stay in the home? If you’re planning to live in your home for only a few years, an adjustable-rate mortgage may be a good option for you. Your payment and rate will be lower, and if you move soon after the initial fixed-rate period ends you’ll avoid the interest rate adjustments.
- Could you still afford your monthly payment if rates increase? If you choose an adjustable-rate mortgage, make sure you’ll be able to afford your payments with any increase in interest rates. If you’re unsure, ask your lender how much your rate can increase so you can be prepared.
Now that you have a better understanding of the differences between a fixed-rate mortgage and an adjustable-rate mortgage, which option will you choose? If you’re looking to purchase a home in the near future, fill out our simple online application, or give us a call. We’d be happy to guide you through the mortgage and home buying process!