Fixed vs. Adjustable Rate Mortgages

The Difference Between Fixed-Rate and Adjustable-Rate Mortgages

Whether you are a first-time homebuyer or refinancing your existing loan, understanding the mortgage process can be intimidating.  When shopping for a mortgage, the two most common products are fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs). Each type of agreement has pros and cons, which often determine how and when you will use them, depending on your financial situation, preference and other factors.

Here is an overview of some of the features of an FRM or an ARM:

Fixed-Rate Mortgage (FRM) Adjustable-Rate Mortgage (ARM)
Interest Rate • Set principal and interest payment for the life of the loan. • Lower at the beginning but subject to changes over time.
• Market shifts determine the changes in rates over the life of the loan.
Complexity • Easy to understand for first-time homebuyers.
• Best for homebuyers who will stay in a home for many years.
• Attractive to homebuyers who expect their income to be stable over time.
• Requires understanding of more complicated interest structure.
• Best for homebuyers who may sell in a few years.
• Attractive to homebuyers who anticipate an increase in income over time.

Fixed Rate Mortgages

Fixed-rate mortgages are generally available in 10-, 15-, 20-, or 30-year terms. As a rule of thumb, your mortgage payment should be no more than one-third of your total gross monthly income. A longer loan term may mean a higher interest rate and paying more for your mortgage in the end, but the payments may be more manageable.

Consider this example of a $250,000 fixed-rate mortgage:

Term APR Monthly Payment Total Paid
10 Year 3.0% $2,414 $289,682
15 Year 3.5% $1,787 $321,697
20 Year 4.0% $1,515 $363,588
30 Year 4.3% $1,237 $445,384

Additional costs: For first-time home buyers, never forget that your property taxes are added to your monthly payment through an escrow account. That means if your taxes will be $6,000 per year, you must add $500 to your monthly mortgage payment. Financing with a down payment of less than 20 percent may require the purchase of mortgage insurance, another consideration to make as you decide about financing.

Adjustable-Rate Mortgages

What is a standard ARM?

Adjustable-rate mortgages carry the same properties as a standard mortgage (escrow, homeowners insurance, personal mortgage insurance, etc.). The difference is that the interest rates adjust at set intervals. One benefit of ARMs is that the interest rate is initially set below that of a comparable fixed-rate mortgage, but then it adjusts based on the market index your financial institution is using. The ARM could adjust every month, quarter or year depending on the terms set by the lender.

What is a hybrid ARM?

The most popular type of adjustable-rate mortgage is the hybrid ARM, which is usually identified by the fraction in its title, such as “5/1 ARM.” This stipulates a fixed rate for the first five years of your loan, but then it will adjust every year thereafter. In this instance, after 5 years your interest rate could potentially be higher than that of a comparable fixed-rate mortgage, depending upon the market index used by the lender.

Does that mean my interest rate could rise indefinitely after the fixed-rate period?

No. Most ARMs have a cap, which limits the amount of interest the mortgage can reach from one period to the next. They also have a lifetime cap or ceiling, which limits the maximum interest rate adjustment that can be made over the life of the loan. A reputable lender will explain these stipulations to you, but don’t hesitate to ask about them.

When does an ARM make sense?

  • When you do not plan on staying at the property for more than a couple of years.
  • If you are expecting to make a significantly higher income and can afford higher payments when the fixed-rate period ends.
  • Interest rates are low and stable and will most likely stay that way. It is possible that after the fixed-rate period, your rate could drop with the market and you will not have to refinance like those who are in a fixed-rate mortgage.

At Bethpage Federal Credit Union, we’re happy to answer any remaining questions you have about FRMs and ARMs. Contact us today to start the application process, consult with our experienced team and begin your journey on the path to homeownership.