Fixed Rate Mortgages Vs. Adjustable Rate Mortgages

Getting the right mortgage for your new home isn’t something to be taken lightly. In today’s real estate market, many people find themselves wondering if they should choose a fixed rate mortgage or an adjustable rate mortgage. In this post, we’ll be outlining what these mean, and give you some insight into which may be best for you.

Fixed Rate Mortgage

This is also often referred to as a “conventional mortgage loan”. This is one of the more common forms of mortgage loans. Essentially, a fixed rate mortgage is a mortgage that has an unchanging (fixed) interest rate, which lasts throughout the “lifespan” of the loan. Those with fixed rate mortgage loans can expect to pay a certain amount each month. That said, there will be some variation in your monthly payment, because although the interest rate itself doesn’t change, your homeowner’s insurance and property tax may fluctuate.

Your payment will be put towards your:

  • Principal: This is the amount of money that you have borrowed from the lender.
  • Interest: This is what the lender charges as payment for lending you the money.

This is what’s known as an “amortized loan”. As with most forms of mortgages, you can choose from a variety of options regarding the time in which you repay the loan, including:

  • 10 years
  • 15 years
  • 20 years
  • 30 years

Generally speaking, you will be paying off the interest first, followed by paying off the rest of the principal amount.

Advantages and Disadvantages of a Fixed Rate Mortgage

Advantages

  • If your income isn’t flexible and you need to depend on a consistent monthly payment, fixed rate mortgages are going to give you more peace of mind. With fixed rate loans, you won’t have to worry about unpredictable interest rates.
  • They aren’t complicated. You can generally understand exactly what you’ll be paying and how it works before signing the contract. You’re unlikely to get confused by any obscure financial language. It also makes it easier to choose which one is best for you.
  • An unpredictable market is less likely to affect you with a fixed rate mortgage. Even if your interest rates were to fluctuate unexpectedly, you will still have protection from a crisis.

Disadvantages

  • If you end up refinancing within the first couple of years of trying to pay off your house, you can end up losing the advantages of the loan. This usually happens when the contract necessitates that you don’t change anything for a specified amount of time in order to keep your rates the same.
  • Your interest rates are generally going to be higher than an adjustable rate mortgage. This is usually dependent on factors like the current interest market, your credit score, and the terms of your loan.
  • The first five to ten years of your loan will likely be more expensive than they would be with an adjustable rate mortgage.
  • If interest rates go down, you’ll end up with a relatively high rate and high payment.
  • Fixed rate mortgages are generally more expensive, so many people end up not qualifying for a loan, or decide against one altogether.

Adjustable Rate Mortgage

Adjustable rate mortgages often include interest rates that are about 2 to 3 percent below a fixed rate mortgage, which opens you up to the possibility of purchasing a more expensive home.

That said, they are also less predictable than fixed rate mortgages. Interest rates fluctuate depending on ever-changing market conditions. So, if interest rates increase, so will your monthly payment. On the other hand, if they go down, the same goes for your monthly payment as well.

There is also sometimes the option of choosing a loan that combines elements of both adjustable rate mortgages and fixed rate mortgages. For example, these might start at a fixed rate for 7 to 10 years, after which time they would be adjusted to market conditions.

It should be clear by now that adjustable rate mortgages are a bit more complicated than fixed rate mortgages.

There are usually two numbers you need to keep in mind when it comes to adjustable rate mortgages.

  1. The number of years in which the rate will be fixed.
  2. A number that could mean many different things, such as the amount of years in which the rate will be variable.

One way this could be expressed would be 3/17, in which the 3 represents the amount of years the mortgage will be fixed rate, and the 17 represents the amount of years it will be variable. It can also be expressed through 4/1, in which the 4 represents the fixed rate years and the 1 represents that the rate will be changed every year following that. Or we could have a 5/6 in which the 5 is the years of fixed rate and the 6 represents it can be changed every 6 months following the 5 year period.

As you can see, there are many variations of this two-number formula, so you need to be sure the one you’re choosing is right for you.

Adjustable Rate Mortgages Are Affected by the Index and the Margin

The index rate and margin are the primary factors that affect your mortgage rate after the fixed rate time span is up.

  • Index: This represents various market forces and is determined by a neutral party. The market is always fluctuating and so is your index. There are many indexes and the one your loan follows will be indicated in your loan documents.
  • Margin: These are fixed percentage points. As with the index, the margin will be included in the loan documents.

The index and the margin combined will determine your new interest rate after the fixed rate period has concluded. For example, if the index is 4% and the loan is 3%, these will be combined to make your rate 7%. Every time your index fluctuates, your overall rate will be adjusted accordingly during evaluation.

Advantages and Disadvantages of Adjustable Rate Mortgages

Advantages

  • If the index drops, your monthly payments will be smaller.
  • Adjustable rate mortgages have rate and payment caps, which are can put a ceiling on how high your monthly payments can grow.
  • They’re more flexible.
  • The interest during the fixed phase is usually low.

Disadvantages

  • If the index raises, your monthly payments will be larger.
  • They’re less predictable. These kinds of mortgages require you to plan ahead for the unknown. Some adjustable rate mortgages come with prepayment penalties, so if you decide to sell or refinance your loan, you will be charged a fee.
  • They’re overall more complicated than fixed rate mortgages.