Fixed and Adjustable-Rate Mortgage: How to Choose

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September 2, 2020

So you’re ready to buy a house and shopping around for a home loan. You’ll need to figure out whether you want a fixed or adjustable-rate mortgage.

What’s the difference between a fixed-rate and adjustable-rate mortgage?
Different kinds of fixed-rate mortgages
Different kinds of adjustable-rate mortgages
How do I decide what kind of mortgage to choose?
How the interest rate environment comes into play
What else should I consider when deciding the kind of mortgage I want?

Choosing type of mortgage

The difference between a Fixed-Rate and Adjustable-Rate Mortgage

When looking for a mortgage, most buyers find that they are presented with many different options. One of the main distinctions is between fixed-rate home loans and adjustable-rate (ARM) home loans. A fixed-rate mortgage is one where the buyer’s interest rate is flat and never can fluctuate while an ARM interest rate can change after a certain period of time, although there’s usually a cap for how high the rate can get. 

Each kind of loan has its own pros and cons. In the beginning, fixed-rate loans tend to be higher than ARM loans—but while the ARM can rise over time—the fixed-rate can’t do that. Also, while borrowers typically have a minimum required down payment of 3% with a fixed-rate mortgage, they’ll likely need to put down at least 5% for an ARM. 

That said, the interest rate on an ARM is also capable of becoming lower over time, depending on external forces on interest rates. So if you get a fixed-rate in a high interest rate environment and want to take advantage of future low rate environments, you’re going to need to refinance which can be a hassle and come with some closing costs. 

But if you’re looking for a more stable mortgage payment, fixed might be the way to go because it never changes. It’s also a little harder to get a fixed-rate mortgage because of this—due to the permanence of the interest rate, fixed-rate lenders tend to look for borrowers with higher credit scores and incomes.

For these reasons, ARMs tend to be more popular with first-time home buyers and people looking at starter homes because of the initial lower rates and subsequent lower short-term payments. However, if you’re looking to settle into a home for the next few decades, the stability of the fixed-rate mortgage might be more appealing.

Most common types of fixed-rate mortgages

Fixed interest rates are set based on the amount of time the borrower wants to take to pay the mortgage off. The most common ones are 30-year and 15-year fixed mortgages. Sometimes, you can also get a 20-year or 10-year mortgage, but these are less common. The factors that differentiate these loans are the interest rates offered, the amount of interest expected to be paid over time, and the cost of total monthly payments.

  • 30-year, fixed-rate: This is the most popular type of fixed-rate mortgage because it comes with the lowest monthly payments and usually allows for the buyer to borrow more money than if they were to go with a shorter term loan.
  • 15-year, fixed-rate: The biggest pro to the 15-year mortgage is that the total interest paid over time will be lower than the 30-year, but the monthly payments will be higher and the total amount of money available will be lower.
  • 20-year, fixed-rate: This type is usually not talked about as much as the other popular two. However, for some, it could be a happy medium between the high, long term costs offered in a 30-year loan and the high monthly payments associated with the 15-year loan. This loan is one that buyers commonly refinance into after taking out a different rate initially, due to the balance of it.
  • 10-year, fixed-rate: These mortgages usually have the lowest interest rates due to how short-term the loan is. However, it’s the most difficult type of fixed-rate mortgage to get, and will often only be offered for low amounts. Because of that, this type of loan is often something that homeowners refinance into later, as opposed to the one they initially take out.

Most common types of adjustable-rate mortgages (ARM)

Adjustable-rate mortgages are a little more complicated to explain than fixed-rate, because of how the interest rate fluctuates. 

ARMs have annual rate adjustments after a set period of time, when the initial fixed-rate term ends. Unlike fixed-rate mortgages that have flexibility in terms of the length, most ARMs are only offered for 30-year terms. Below are examples of the most common types:

  • 5/1 ARM: This loan has a static rate for the first 5 years, and an adjusting rate on an annual basis for the next 25 years. Might be a good choice for someone who expects to move frequently.
  • 7/1 ARM: This loan has a static rate for the first 7 years and an adjusting rate on an annual basis for the next 23 years. A little more stable than the 5/1 but not as much as the 10/1. This could be good for someone getting a starter home.
  • 10/1 ARM: This loan has a static rate for the first 10 years and an adjusting rate on an annual basis for the next 20 years. This is better for borrowers who need a little more long term stability than the other two.

How should you decide what kind of mortgage to choose?

The type of mortgage that you choose will depend on a lot of factors. How much you can afford per month? What’s your risk tolerance? For how long do you expect to live in the home? What have you been actually offered by lenders? These are all important questions to ask yourself. If you’re still trying to decide between a fixed-rate mortgage or ARM, here are some pros and cons for each:

Prose and Cons of Fixed-Rate Mortgages

Pros:

  • Better for a tight budget, stability in payments.
  • If interest rates are low, you’re locked into the low rate.
  • More choices in the length of your mortgage (30, 20, 15, or 10 years).

Cons:

  • Harder to get, need high credit, and good income.
  • If interest rates get lower over time, you’ll need to refinance to take advantage of them.
  • Higher monthly payments than the first years of an ARM.

Pros and Cons of Adjustable-rate Mortgages

Pros:

  • Your credit score and income don’t need to be as high.
  • Good if you’re not planning on staying in the home for a long period of time.
  • They’re much cheaper the first few years than fixed-rate mortgages.
  • Lower interest rates, in the beginning, means its possible to pay down more of the principal loan at first.
  • If interest rates are high, you can get a lower rate during those first few years.

Cons:

  • It’s risky, you could end up paying a lot more in interest than anticipated over time.
  • Can be troublesome if rates go up and your mortgage is really large to begin with.

How the interest rate environment comes into play

There are many factors that come into play when lenders calculate what interest rate they want to offer you. Some of it has nothing to do with you specifically as the buyer. The general state of the economy plays a big role in what interest rates are offered on mortgages for everyone. 

Simply put, when the overall demand for housing is weak—like during a recession—interest rates will be lower. Rates can also become lower when supply increases. This is the case when the Federal Reserve pumps cash into the American economy in an attempt to increase activity. Conversely, the opposite happens during economic “booms” when people make a lot of big purchases like homes and cars. During times like that, it makes sense for lenders to raise interest rates to maximize their own returns. Therefore, it’s good to be aware of what general market conditions are when you want to buy a house. 

Sometimes even if you’re a low-risk person planning on staying in a home for a long time, it still might make sense to go for an ARM. This will depend on the overall interest rate environment. If rates are really high and you think that they might go back down later, getting an ARM makes sense. Similarly, if rates are really low, it might make sense to go for a fixed-rate. This way, your lender can’t raise your rate later on, no matter how high interest rates get. 

That said, ARMs did go somewhat out of favor with many financial planners after the housing bubble burst in 2008. Prior to the financial crisis, a lot of lenders offered attractive ARMs without considering many borrowers’ realistic ability to pay. Many borrowers later became blindsided by skyrocketing payments after mortgage rates adjusted a few years after they took them out. This led to an unprecedented amount of foreclosures and short sales of homes. Fortunately, since then there have been some protections put in place by the Consumer Protection Financial Bureau to prevent predatory lending practices from recreating this crisis.

What else should I consider when deciding the kind of mortgage I want?

Something really important to remember is that there are other factors that will affect which kind of mortgage is best for you. Based on other aspects of your application, the lenders that you speak to might only offer you certain kinds of mortgages or offer you mortgage types that you want at rates that you don’t want. If you’re thinking about these other factors, check out our guide on how your credit score will affect your mortgage, and about the mortgage pre-approval process.

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