Buying a house is a big deal. The terms, interest rate and the type of loan you choose have a lasting impact on your payments. When shopping for a home loan, you’ll come across two basic types of mortgages: fixed-rate mortgages and adjustable-rate mortgages (ARMs).
How Fixed-Rate Mortgages Work
With a fixed-rate mortgage, the interest rate you receive at the beginning of the loan stays the same throughout the term. That means you’ll make the same payment every month until you pay off the loan, refinance it or sell the home. This is good news for borrowers who can lock in a low rate as it reduces the overall cost of the loan.
How Adjustable-Rate Mortgages Work
There are two distinct periods to an adjustable-rate mortgage: the fixed period at the beginning of the loan and the adjusted period that follows.
You’ll start with a lower introductory rate for the first few years of your mortgage (the fixed period), and then you’ll enter the adjusted period where the rate can change periodically—usually once or twice a year—depending on your terms.
For example, a 5/1 ARM gives you a fixed interest rate for the first five years of your mortgage. After that, the rate adjusts once a year.
Related: Is Now A Good Time To Get An ARM?
Fixed-Rate Mortgage vs. Adjustable-Rate Mortgage Example
Say you get a $400,000 home and put 20% down ($80,000) with a fixed interest rate of 5% and a 30-year term. Your monthly principal and interest payments would amount to approximately $1,700 and won’t change for the life of the loan. Remember that you’ll also need to factor in taxes and insurance.
If you get a 5/1 ARM with the same figures but a lower initial interest rate—let’s say 3.75%—the first five years of payments would start at just under $1,500 a month. Should market conditions stay about the same, you would spend about $67,000 less in interest than the fixed-rate loan.
Differences Between Fixed-Rate and Adjustable-Rate Mortgages
The biggest difference between a fixed-rate and adjustable-rate mortgage is that the interest rate never changes for a fixed-rate loan, while the rate on an ARM may change several times throughout the loan term. A few other key differences between the two loan types include:
- Budgeting. Once an ARM enters the adjusted period, it may be more difficult to budget as the monthly payment can change frequently. A fixed-rate mortgage, however, offers the same payment for the life of the loan.
- Qualifying. Compared to fixed-rate mortgages, lenders typically have more lenient borrower requirements when it comes to ARMs since payments are lower at the beginning of the term.
- Affordability. Fixed-rate mortgages tend to be more expensive than ARMs as they come with higher interest rates in exchange for the security of a set rate. But if mortgage rates go up in the future, the extra expense at the beginning of a fixed-rate loan may ultimately prove worth it.
Similarities Between Fixed-Rate and Adjustable-Rate Mortgages
No matter which type of loan you choose, you’ll encounter some similarities. Both fixed-rate and adjustable-rate mortgages share the following characteristics:
- Term length. Both fixed-rate loans and ARMs offer 15-year and 30-year terms. If you want to keep monthly payments as low as possible, opting for a longer term is usually your best option.
- Refinancing. You have the ability to refinance both fixed-rate and adjustable-rate mortgages. If you have an ARM that you want to get out of before the fixed period ends, you can refinance into a fixed-rate mortgage. At the same time, if you paid a higher rate at the beginning of your fixed-rate mortgage, you can always refinance down the line once rates drop.
- Lenders. Fixed-rate and adjustable-rate mortgages are popular options and many of the best mortgage lenders offer both as a result. This is convenient for borrowers as you can compare the cost of each product simultaneously.
How To Choose Between a Fixed-Rate and Adjustable-Rate Mortgage
The type of mortgage you get matters. Choosing an ARM or a fixed-rate mortgage can cost you thousands of dollars more or less, depending on the circumstances. To determine the best option for yourself, start by considering what your financial goals are and what you plan to do with the house in the long term.
You might want to get a fixed-rate mortgage if you:
- Plan on staying in the home for 10 years or more
- Enjoy predictable payments
- Are a first-time home buyer looking for a more straightforward option
You may want to explore an adjustable-rate mortgage if you:
- Plan on leaving the home before the fixed introductory period ends
- Can budget fluctuating payments
- Expect interest rates to stay the same or decrease as long as you’re holding the loan
Bottom Line
With so many different types of mortgages on the market, it’s important to explore and compare options. You may want to take a chance with an ARM, for instance, if current mortgage rates are high. ARM rates are typically lower than fixed rates, so you can often get a better deal during the first few years of the loan.
Another reason to consider an ARM is if mortgage rates are trending downward or you plan to sell the home within a few years. But if you’re on a strict budget and can’t afford potential fluctuations, a fixed interest rate may work better for you. Fixed-rate mortgages are also a simpler option to understand and budget for, which can be helpful for first-time home buyers.
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