Fixed Rate vs. Adjustable: Which Mortgage Is Right for You?
When you're choosing a mortgage, there are many factors to consider. Your own personal finances will probably experience periods of increase and decline, interest rates rise and fall, and the strength of the economy waxes and wanes.
With that as context, let's take a closer look at each basic type of mortgage:
In a fixed-rate mortgage, the interest rate is fixed, which means you're protected from increases in monthly mortgage payments. The total amount of interest you'll pay depends on the mortgage term. The 30-year mortgage is the most popular, because it offers the lowest monthly payment. The trade-off is a higher overall cost — the extra decade is primarily devoted to paying interest. Monthly payments for shorter-term mortgages are higher — the principal is repaid in a shorter time frame. Short-term mortgages offer a lower interest rate, allowing for a larger amount of principal repaid with each mortgage payment.
Adjustable-rate mortgages offer variable interest rates. Initial interest rates are set below the market rate for a comparable fixed-rate loan, and they rise over time. If the adjustable-rate mortgage is held long enough, the interest rate will surpass the going rate for fixed-rate loans. There are "brakes" — caps on the maximum amount your rate can increase.
ARMs have a fixed period in which the interest rate is constant and then adjusts at a prearranged frequency. Shorter adjustable periods generally carry lower initial interest rates and reset based on current market rates. A big advantage of taking out an ARM is that it's usually less expensive than a fixed-rate mortgage for the first three, five or seven years. The low initial payments enable the borrower to pay lower interest rates without having to refinance.
But there are downsides to taking out an ARM.
- Your monthly payment may change frequently. You could be in trouble when interest rates rise. Some ARMs are structured so that interest rates can nearly double in a few years.
- During the subprime mortgage meltdown, borrowers saw their ARM payments skyrocket. Since then, government regulations and legislation have increased oversight to help avoid such scenarios.
Clearly, ARMs are more complex than fixed-rate mortgages. If you're considering an ARM, consider how high your payments could conceivably get. If you can afford a mortgage reset to the maximum cap, an ARM will save you money every month. Use the money you saved by not taking a fixed-rate mortgage to make extra payments on the principal, so that when the reset occurs, the total loan is smaller.
If interest rates are high and expected to fall, an ARM will ensure you take advantage of the drop because you're not locked into a particular rate. If interest rates are climbing, a fixed rate may be the way to go.
If you don't plan to live in the property long enough to see rates rise, you'll have low payments. If you know you're going to move shortly or you don't plan to hold on to the house for decades, then an ARM makes a lot of sense. Similarly, if you have a stable income that's not expected to increase, go with a fixed-rate mortgage. But if you expect to see a great increase in your income, going with an ARM could save you from paying lots of interest.
The bottom line? Choose carefully and don't make assumptions. This is just an introduction and there are other factors. Financial and real estate professionals can help you make the right decision.