Introduction
Purchasing a home is one of the most important financial choices in life, and selecting the appropriate type of mortgage is an important factor in maintaining long-term financial health. Mortgages typically fall into two main categories: Fixed-Rate Mortgages (FRMs) and Adjustable-Rate Mortgages (ARMs).
Both types of loans have different pros and cons based on various factors like financial objectives, term of the loan, market, and risk tolerance. Knowledge about these mortgage choices will enable you to make an informed choice, ensuring that your home loan fits your financial goals.
In this article, we will take a closer look at the differences, advantages, disadvantages, and appropriateness of each kind of mortgage so that you can decide which is most suitable for your requirements.
Understanding Fixed-Rate Mortgages (FRMs)
A Fixed-Rate Mortgage (FRM) is a mortgage in which the interest rate is fixed over the entire duration of the loan. A 15-year, 20-year, or 30-year mortgage is something you can opt for, and your monthly interest and principal payments will not change.
How Fixed-Rate Mortgages Work
When you borrow a fixed-rate mortgage, you commit to paying a fixed interest rate for the entire term of the loan. That means that even though market interest rates may change, your mortgage rate and monthly payment will remain unchanged. This kind of mortgage best suits borrowers who value financial stability and predictability.
Benefits of Fixed-Rate Mortgages
Fixed Monthly Payments – Because the interest rate is fixed, your monthly mortgage payment is constant, so you can budget and plan your finances with ease.
No Fear of Rises in Interest Rates – You are protected against increasing interest rates, securing your long-term finances.
Long-Term Security – A fixed-rate mortgage is the best option for homeowners looking to remain in their house for many years.
Simpler to Comprehend – Fixed-rate mortgages are easy to understand, and so easier for first-home buyers to realize.
Drawbacks of Fixed-Rate Mortgages
High Initial Interest – Fixed-rate loans typically bear higher initial interest rates than do adjustable-rate mortgages.
No Room for Maneuver – If market interest rates fall, you won’t be able to take advantage of this unless you refinance your mortgage, for which there is often a charge.
Potentially Higher Total Interest Costs – Throughout the life of the loan, fixed-rate mortgages can have higher total interest paid than ARMs, particularly if rates are low.
Understanding Adjustable-Rate Mortgages (ARMs)
An Adjustable-Rate Mortgage (ARM) begins with a reduced fixed interest rate for a term, e.g., 5, 7, or 10 years, and then varies periodically according to market rates. Once the fixed period is over, the interest rate may go up or down according to the benchmark interest rate to which the loan is connected.
How Adjustable-Rate Mortgages Work
ARMs typically consist of two phases:
- Fixed-Rate Period – The interest rate does not change for a fixed duration, usually 5, 7, or 10 years. During these years, the borrower enjoys smaller monthly payments than with a fixed-rate mortgage.
- Adjustment Period – After the fixed term is over, the interest rate is periodically changed, typically once a year or half-yearly, depending on market conditions. The new rate is calculated by adding a margin to a benchmark index rate (e.g., the U.S. Treasury rate or the Secured Overnight Financing Rate).
Advantages of Adjustable-Rate Mortgages
Lower Initial Interest Rates – ARMs tend to have lower initial interest rates compared to fixed-rate mortgages, and they are therefore popular among borrowers seeking temporary savings.
Potential for Lower Long-Term Costs – If market interest rates fall in the future, borrowers can enjoy lower payments without having to refinance.
Short-Term Homeownership Friendly – If selling or refinancing is planned prior to the adjustment period, borrowers can enjoy the lower initial interest rate without any concern for eventual rate hikes.
Increased Chances of Higher Loan Qualification – With the reduced initial interest rate, borrowers could qualify for a higher loan, allowing them to buy a higher-priced home.
Disadvantages of Adjustable-Rate Mortgages
Uncertain Future Payments – After the fixed-rate period ends, your interest rate may increase significantly, leading to higher monthly payments.
Complex Loan Structure – ARMs can be more difficult to understand compared to fixed-rate mortgages, making it important to read the loan terms carefully.
Risk of Financial Instability – When interest rates in the market increase significantly, monthly installments become unaffordable, leading to higher chances of loan default.
What to Consider When Deciding Between a Fixed-Rate and an Adjustable-Rate Mortgage
The choice between an FRM and an ARM depends on a number of key considerations, including:
1. Your Financial Stability
- If you have a stable income and want predictable payments, a fixed-rate mortgage is a better option.
- If you anticipate that your income will grow substantially in the near future, you might feel more at ease with an ARM.
2. Your Long-Term Plans
- If you expect to remain in your house for over 10 years, a fixed mortgage is typically best.
- If you think that you will refinance or move in 5 to 7 years, an ARM might have short-term advantage.
3. Today’s Market Situation
- When interest rates are low, taking a fixed mortgage rate is advantageous.
- If rates are high but predicted to fall, an ARM could be a good choice, where you can take advantage of lower rates in the future.
4. Risk Tolerance
- If you like financial predictability and don’t want to deal with variable payments, a fixed-rate mortgage is the way to go.
- If you are willing to take some risk in exchange for lower initial payments, an ARM could work well.
5. Potential for Refinancing
- If you choose a fixed-rate mortgage and interest rates decrease, you may need to refinance, which involves closing costs and fees.
- If you choose an ARM, you can probably refinance to a fixed-rate mortgage prior to the adjustable period.
Which Mortgage is Right for You?
Here’s a quick summary to assist you:
- Select a Fixed-Rate Mortgage if:
- You like stable monthly payments.
- You intend to stay in your home for many years.
- You don’t want interest rate increases.
- Select an Adjustable-Rate Mortgage if:
- You expect to sell or refinance in a short time.
- You desire lower initial payments.
- You are willing to accept possible rate changes.
Detailed Comparison: Fixed-Rate and Adjustable-Rate Mortgages
To further differentiate, let’s compare fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs) on different aspects that affect homebuyers.
| Factor | Fixed-Rate Mortgage (FRM) | Adjustable-Rate Mortgage (ARM) |
|---|---|---|
| Interest Rate Stability | Remains steady over the entire loan term | Varies after the introductory period that is fixed |
| Starting Interest Rate | Typically higher than ARMs | Lower for the first term but can be volatile later |
| Long-Term Cost | Higher overall interest paid in the long run | Could be lower if interest rates fall |
| Monthly Payment | Fixed and predictable | Can increase or decrease after the fixed period ends |
| Market Sensitivity | Not sensitive to market fluctuations | Highly sensitive to market interest rate changes |
| Best for | Long-term homeowners, those who want financial security | Short-term homeowners, risk-taking borrowers |
| Risk Level | Low | Higher due to uncertainty after the fixed period |
This chart gives a brief overview of the inherent differences between these types of mortgages.
Fixed-Rate vs. Adjustable-Rate Mortgages: Real-Life Scenarios
Let’s consider various homeowner scenarios and what mortgage choice might be best for them.
Scenario 1: A First-Time Homebuyer Planning Long-Term Residency
Meet Sarah, a first-time homebuyer with a steady job and an intention to occupy her home for a minimum of 15 years. She desires steady monthly payments and avoids uncertainty of finances.
Best Choice: Fixed-Rate Mortgage
Sarah enjoys constant payments and escapes the uncertainty of future rising interest rates.
Scenario 2: A Young Professional Anticipating a Career Reassignment
Meet James, a young professional who is buying a house but anticipates moving in the next five years because of his career.
Best Option: Adjustable-Rate Mortgage
Because James will probably move before the ARM’s fixed-rate period expires, he can enjoy lower initial interest rates without concern for rate changes.
Scenario 3: A Homebuyer Anticipating Interest Rates to Fall
Lisa and Mark are a homebuying couple who are doing so when interest rates are relatively high. They expect rates to fall in the future.
Most Suitable Choice: Adjustable-Rate Mortgage (with intent to refinance in the future)
They can lock into a lower early rate with an ARM and then refinance into a fixed-rate mortgage when rates fall, keeping them from having to pay a lot of money in interest over time.
Scenario 4: A Retiree Seeking Stability
Robert is a retiree who desires to purchase a home and reside there the remainder of his life. Being on a fixed income, he prefers fixed mortgage payments.
Best Option: Fixed-Rate Mortgage
Robert appreciates predictable monthly payments that will not alter, providing stability in his finances during his retirement.
Other Costs to Factor in with Fixed and Adjustable-Rate Mortgages
Whether it is an FRM or an ARM, borrowers must keep in mind other costs that affect overall affordability:
1. Closing Costs
Both FRMs and ARMs come with closing costs, such as:
- Loan origination fees
- Appraisal fees
- Title insurance
- Attorney fees
2. Property Taxes and Insurance
Homeowners’ insurance and property taxes need to be paid in addition to the mortgage. These fees can change, even if you have a fixed-rate mortgage.
3. Mortgage Insurance
If your down payment is lower than 20%, you will have to pay Private Mortgage Insurance (PMI) on a conventional loan. PMI is an added expense each month but can be dropped once you have 20% equity in your home.
4. Refinancing Costs
If you opt for an ARM and in the future refinance to a fixed-rate mortgage, refinancing charges, such as closing expenses and potential prepayment penalties, must be considered in your choice.
