Mortgage Basics: Fixed vs Adjustable Rate Mortgages
Choosing the right mortgage for you can be confusing, but is also extremely important. There are many different mortgage products and lots of confusing terms. Two of the most popular types of mortgages sold today are Fixed Rate Mortgages (FRMs) and Adjustable Rate Mortgages (ARMs). Here’s a quick guide to the basics of each loan type.
Fixed Rate Mortgages. The most popular type of loan, FRMs are sold with the interest rate fixed for the length of the loan. They are commonly sold in 10, 15, 20, 25, and 30 year terms, though some lenders are beginning to stretch out the terms to 40 and even 50 years. As a general rule, longer terms are sold at higher interest rates when compared to shorter term, but they also have lower monthly payments. FRMs are typically sold at higher interest rates than ARMs, as mortgage lenders must account for the unpredictable costs of interest rate changes over the life of the loan.
Advantages
- Monthly mortgage payments are predictable and stable
- Less risky in the event market conditions cause interest rates to rise. With a FRM, you have locked in your interest rate for the life of the loan
Disadvantages
- You pay more interest vs. an ARM
- Unable to take advantage of lower interest costs if the market causes interest rates to drop
Good When
- You plan to stay in the home for a long time
- You feel you have a very good interest rate and want to keep it for the length of your loan
- You prefer the security of a fixed payment vs. a payment that may change periodically
- If you want to pay off your mortgage before your children go to college, a 20 or 15 year FRM will allow you to build equity more quickly, freeing up future income
Adjustable Rate Mortgages. There are a wide variety of ARMs available. ARMs are often sold with an initial interest rate, guaranteed for a pre-specified period of time, after which the interest rate will adjust to reflect market conditions and continue to adjust at pre-specified intervals. They are commonly sold in 1/1, 3/1, 5/1, 7/1, and 10/1 terms. For example, if you purchased a 5/1 ARM, your initial interest rate is guaranteed for five years, after which, your interest rate will adjust and would continue to adjust every year over the course of the loan. ARMs are typically sold with “caps” and “floors” that limit the maximum adjustment as well as establish maximum and minimum interest rates over the life of the loan.
Advantages
- Lower initial monthly payments
- Lower cost for short-term ownership
- Easier qualification for larger loan amounts
Disadvantages
- More risk
- Potentially higher future mortgage payments if interest rates rise
- Future mortgage payments are less predictable
Good When
- You plan to sell or refinance within a few years
- You are comfortable with less predictable mortgage payments that periodically adjust to reflect interest rates