Fixed vs. Adjustable Rate Mortgages

Whether you are a first-time homebuyer or refinancing your existing loan, understanding the mortgage process can be intimidating. In the following, we will explain the two most common types of mortgages.

The Difference Between Fixed-Rate and Adjustable-Rate Mortgages

When shopping for a mortgage, the two most common products are Fixed-rate mortgages and Adjustable-rate mortgages (ARMs). Each type of product has pros and cons, which often determine how and when you will use them. The type of mortgage you get could also depend on your financial situation. With a FRM, you may have a higher fixed interest rate than what is typical at the beginning of an ARM, but if it is within your budget and you plan on staying in your home for many years, you may prefer to have a set monthly payment for the life of the loan. Fixed-rate mortgages are generally easier to understand and sometimes make the most sense for first-time homebuyers. However, should mortgage rates fall significantly in the future and you want to take advantage of a better rate, then you will have to refinance and pay closing costs to do so.

Fixed Rate Mortgages

Fixed rate mortgages are generally available in 10-, 15-, 20-, or 30-year terms. Generally, if you choose to pay your mortgage in a shorter amount of time by going with a product such as a 10-year mortgage, the interest rate will be lower. However, it is important to make sure that you will be able to handle the higher monthly payment. As a rule of thumb, your mortgage payment should be no more than 1/3 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.

Take the following examples:


For a $250,000 mortgage:

Term

APR

Monthly Payment

Total Paid

10 Year

3.0% APR

$2,414

$289,682

15 Year

3.5% APR

$1,787

$321,697

20 Year

4.0% APR

$1,515

$363,588

30 Year

4.3% APR

$1,237

$445,384

 

For you 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. There is also mortgage insurance that is required and if you do not put a certain amount down towards the purchase of the home (usually 20%), you could also be paying personal mortgage insurance.

Understanding ARMs

Adjustable-rate mortgages carry all the same properties as a standard mortgage (escrow, homeowner’s 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 whatever market index the financial institution is using. The ARM could adjust every month, quarter, or year depending on the terms set by the lender. 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 means that you have a fixed rate for 5 years of the 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. Be sure to ask your lender if you are considering an adjustable-rate mortgage.

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.

What are points, and why would I have to pay them?

If you go through the mortgage application process and it turns out that your credit score is not where it needs to be, then you often have to make a choice; you can either take a higher interest rate, because your credit score indicates you are a higher risk as a borrower, or you can “purchase” the lower interest rate by paying points.