Each one has its benefits and the informed home buyer or refinancer will want to understand how both loan types works to enable the home buyer or refinancer to make the best choice.
Fixed Rate Mortgages
A fixed-rate mortgage is exactly what it sounds like. It’s a mortgage for which the interest rate is fixed for the life of the loan.
Fixed rate mortgages are available in multiple terms, where “term” is used to describe the length for which the mortgage contract is in place. With a fixed-rate mortgage, when the term is complete, the loan is paid-in-full.
As you may suspect, the monthly payment required for fixed-rate loans increase as the loan term reduces. This is because, with a shorter loan term, the homeowner is repaying the mortgage lender over a lesser period of time.
The upside of assuming the larger payment that comes with a shorter fixed rate loan term is that mortgage rates are often lower, and the amount of mortgage interest paid over the loan’s lifetime is less, too.
The main benefits of a fixed rate mortgage are linked to its predictability. With a fixed-rate mortgage, your mortgage payment is set on Day 1 of your home loan, and never changes until the loan is paid-in-full. Some homeowners like this.
Adjustable-Rate Mortgages
The adjustable-rate mortgage (ARM) is a mortgage for which the interest rate can vary over time.
Mortgage rates are often lower with an adjustable-rate mortgage versus for a comparable fixed rate loan because the homeowner assumes some of the long-term interest rate risk which is fully-assigned to the bank with a fixed-rate loan.
Most ARMs works like this:
- For some preset, fixed number of years, the ARM’s mortgage rate remains unchanged
- After the fixed period ends, the mortgage rate changes based on a preset formula
- Annually, the ARM’s mortgage rate changes again based on the same formula
Adjustable-rate mortgages adjust once per year until the original loan balance is paid in full, usually in 30 years. Note that some ARMs exist which adjust every six months, but they are uncommon. Annual adjustments are most prevalent.
When ARMs adjust, the “adjusted mortgage rate” is a sum of two numbers — a constant figure called a margin and a variable figure called an index. When you add the (margin) to the (index), you get your new rate.
The most common index used for ARMs is the 12-month LIBOR rate, which is currently 0.67%. Margins are typically 2.5%. Today’s homeowners with adjusting mortgage rates, therefore, get new mortgage rates near 3.17%.
The good news is that adjustable-rate mortgages cannot adjust too high, too quickly. This is because ARMs come with “adjustment caps” — limits in how far an adjustable-rate mortgage’s mortgage rate can change during any one adjustment period.
The adjustment caps often vary by the ARMs initial fixed-rate period.
- 3-Year ARM : Rate doesn’t change for the initial 3 years, after which it can change up to ±2% annually, and after which it may never be more than ±6% from the initial mortgage rate.
- 5-Year ARM : Rate doesn’t change for 5 years, after which it can change up to ±5% at the first adjustment, and after which it can change up to ±2% annually, and after which it may never be more than ±5% from the initial mortgage rate.
- 7-Year ARM : Rate doesn’t change for 7 years, after which it can change up to ±5% at the first adjustment, and after which it can change up to ±2% annually, and after which it may never be more than ±5% from the initial mortgage rate.
Adjustment caps protect homeowners from a rapidly-rising index such as LIBOR, limiting how far an ARM can adjust in any given year.
Which Is Better For You: Fixed Or Adjustable Rate Mortgage
There are a lot of reasons to choose a fixed-rate mortgage over an adjustable-rate mortgage; just as the reverse is true. The “best” product will depend on your individual risk tolerance and your short- and long-term financial goals.
Though, in recent years, as fixed rate mortgage rates have dropped, the relative value of an ARM’s low starting mortgage rate has diminished.
Furthermore, certain ARMs including those made in “high-cost areas” may require larger down payments than comparable fixed-rate loans.
Lastly, with ARMs, there are fewer low-closing cost and zero-closing cost mortgage options so talk with us about which product fits you best.
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