Q: I’m in the market for a home loan and I’ve been exploring my options. Should I finance my new home purchase with a fixed-rate mortgage or an adjustable-rate mortgage?
A: For most people, buying a home is the most significant investment they’ll ever make in their lifetime. It’s a complex process involving several steps, like choosing the type of mortgage for financing the purchase. Two common types of mortgages are fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs). Let’s explore the differences between the two so you can make an informed decision when choosing the mortgage option that best fits your goals and financial picture.
What is a fixed-rate mortgage?
A fixed-rate mortgage is one where the interest rate remains constant throughout the life of the loan. This means the borrower’s monthly mortgage payments also remain unchanged, even if the market interest rates change. FRMs are usually available in 15- and 30-year terms, but 10- and 20-year terms are somewhat common as well.
FRMs are suitable for borrowers who plan to stay in their homes for a long time and want to avoid risking the possibility of rising interest rates.
What are the pros and cons of fixed-rate mortgages?
FRMs have several advantages, including:
- Stability
- Predictability
- Protection against rising interest rates
However, FRMs also have disadvantages, including:
- Higher interest rates
- Limited flexibility
- Less opportunity for savings if interest rates decline
What is an adjustable-rate mortgage?
An adjustable rate mortgage is a type of mortgage in which the interest rate fluctuates periodically based on an index, such as the prime rate or the Treasury bill rate. This means the borrower’s monthly mortgage payments can increase or decrease over time, depending on changes in market interest rates.
ARMs tend to have lower interest rates than FRMs, making them an attractive option for homebuyers who want to save money on interest payments. They can also be a great choice for borrowers who plat to sell their homes or refinance their mortgages before the interest rates rise significantly.
There are several types of adjustable-rate mortgages, including:
- Hybrid ARMs. A hybrid ARM has a fixed interest rate for an initial period, after which the rate becomes adjustable.
- Interest-only ARMs. An interest-only ARM allows the borrower to pay only the interest on the loan for a certain period, after which the payments increase to include the principal.
- Option ARMs. An option ARM allows the borrower to choose the monthly payment amount, including a minimum payment option that can result in negative amortization.
What are the pros and cons of adjustable-rate mortgages?
ARMs have several advantages, including:
- Lower interest rates
- Potential savings if interest rates drop
- Increased flexibility
However, ARMs also have several disadvantages, including:
- Higher risk of rising interest rates
- Uncertainty and unpredictability
- More difficult to budget and plan for future expenses
How do I choose the mortgage that’s right for me?
When choosing a mortgage, be sure to consider the following factors to help you determine which mortgage type is best for you:
- Your current financial situation. Can you afford the higher interest rate on an FRM?
- Your long-term plans. Do you plan to stay in this home for the full 15- or 30-year term? If you plan to move before this time, you may want to choose an ARM.
- Current market conditions. Are interest rates currently rising or falling? If they are rising, a FRM may be the better choice, with the converse being true if rates are falling.
- Your personal money management style. If you prefer to have your dollars and cents lined up neatly as much in advance as possible, you may prefer the predictability of a FRM.
Be sure to consider each of these factors carefully, and to shop around for a lender before settling on a mortgage.
When buying a house, you’ll need to make lots of decisions. One of these, choosing between a fixed-rate mortgage and an adjustable-rate mortgage, will impact your finances for years to come. Use this guide to learn the differences between these two mortgage types and to make the best decision for your home loan.
Your Turn: Have you chosen between an FRM and an ARM? Tell us about it in the comments.