When purchasing a new home, there are so many different things to consider. Not only are you looking for a home that fits all your needs, but you are making decisions on which loan features, such as fixed-rate or adjustable-rate, will work best for your needs. When making this decision, you must understand the differences between fixed-rate mortgage vs adjustable-rate mortgage and the advantages and disadvantages both offer.
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Overview: fixed-rate mortgage and adjustable-rate mortgage
When looking at both mortgage options, the main difference between a fixed-rate mortgage and an adjustable-rate mortgage is the interest rate. Here we take a closer look at each mortgage type and what it means.
Fixed-rate mortgage
Fixed-rate mortgages offer a set interest rate that remains unchanged throughout the life of the loan. In this case, your monthly mortgage payment remains the same every month, allowing you to budget your housing expenses easily. This keeps you protected from any changes in interest rates during the term of your loan.
Adjustable-rate mortgage
An adjustable-rate mortgage works a little bit differently. When you initiate the loan, the interest rate is often set below the current market rate for a fixed-rate loan. This rate is set for a short fixed-rate time, ranging from a few months to up to 10 years. After this initial period, however, the interest rate is reset, meaning that a new interest rate is applied to your mortgage. How often your interest rate resets depends on the terms of your loan. This change in interest rate will adjust your monthly payment and can make it more difficult to budget monthly housing expenses over the course of your loan.
ARM concepts
When considering an adjustable-rate mortgage (ARM), there are some terms you need to become familiar with. These include
Adjustment indexes: This refers to the published market index of specific assets, such as treasury bills, that are used to determine the interest rate at the time of origin or interest rate reset.
- Adjustment frequency: This refers to the frequency of interest rate resets established in your ARM terms
- Margin: In the terms of your ARM, you will agree to a rate that is a certain percentage higher than that of the adjustment index. This percentage amount is considered the margin.
- Caps: This refers to a limit on the amount an interest rate can increase at each adjustment point. In addition, some ARMs will offer a monthly payment cap, meaning the adjustments cannot take your monthly payment over a certain amount.
- Ceiling: This is the highest that your adjustable interest rate can be reset during the life of the loan.
Similarities between ARM and fixed-rate mortgages
Despite differences when it comes to interest rates, ARM and fixed-rate mortgages are similar in a couple of ways.
Term length
While interest rates may fluctuate during the terms of the loan with an ARM, both ARMs and fixed-rate mortgages offer the same term lengths. The most common terms available are 15-year and 30-year mortgages.
Credit requirements
Whether you are applying for an ARM or a fixed-rate mortgage, your lender is going to look at the same qualifying criteria, including your credit score. While both loan options typically follow the same credit score standards, lower scores may have an easier time qualifying for an ARM because of the initial lower monthly payment reducing the debt ratio.
Differences between ARM and fixed-rate mortgages
As we mentioned, the main difference between ARMs and fixed-rate mortgages is the interest rate, other factors set these two mortgage types apart.
Interest rates
Interest rates with an ARM are typically lower than those of a fixed-rate mortgage for the first few years. This allows for lower monthly payments at the start of the loan, making it more appealing for first-time home buyers. As your loan adjusts, however, the interest rates can increase. With a fixed-rate mortgage, interest rates may be slightly higher, however, they will remain at the rate even if interest rates increase.
Rate caps
Rate caps are used to limit the amount that your interest rate can rise or fall during a single adjustment period and during the life of the loan. Even if the interest rates rise higher, this cap will prevent you from exceeding a dramatic price increase.
Margins
Margins are the number of percentage points that are added by your lender to the index that is used to set your interest rates when they adjust.
Ease of qualification
For those with a higher debt-to-income ratio, it may be easier to qualify for an ARM than it is for a fixed-rate mortgage.
Example: fixed vs. adjustable-rate mortgage
| 30-year fixed | 30-year fixed | |
|---|---|---|
|
Mortgage Amount |
$300,000 |
$300,000 |
|
Interest Rate |
6.00% |
4.25% initial |
|
Monthly Payment |
$1,799 for the life of the loan |
$1,476 for initial 5 years and then reset to unknown |
Which is better: fixed or ARM?
Which mortgage type is best for you depends on many different factors. How long do you plan on staying in the home? How frequently will the ARM adjust? Can you afford monthly payment increases over time? To get a better understanding of which loan may be best for you, let’s look at some of the pros and cons.
Pros and cons of a fixed-rate mortgage
| Pros | Cons |
|---|---|
|
✔️ Rates remain constant |
❌ If interest rates drop, you must refinance
|
|
✔️ Same monthly payments make budgeting easier
|
❌ Higher interest rates mean you will pay more over the life of the loan |
|
✔️ Easier to understand loan terms |
|
|
✔️ Ideal for buying your “forever” home |
|
Pros and cons of an adjustable-rate mortgage
| Pros | Cons |
|---|---|
|
✔️ Lower initial payments and interest rates |
❌ Interest rates can go up significantly over the life of the loan
|
|
✔️ If interest rates fall, so will yours during a reset, meaning no need for refinancing |
❌ Changes in interest rates mean payments will change, making it difficult to budget |
|
✔️ Better option for those that do not plan on living in the home long-term |
❌ Sometimes caps do not apply to the initial reset, meaning you could be in for a shock |
|
|
❌ Can be difficult to understand the loan terms |
Choosing the right mortgage terms for you
Navigating the world of home mortgages can be overwhelming and challenging even to the most experienced home buyers. However, choosing the right mortgage for you will make all the difference down the road. At Hero Home Programs, we specialize in finding the right lending solution for our borrowers, helping to ensure they can move into the home of their dreams. To learn more about how we can help you find the right mortgage for you, schedule a consultation with us today.
