Understanding Fixed-Rate and Adjustable-Rate Mortgages

When you’re shopping for a mortgage loan, one of your first major decisions is what type of interest rate to get. Your options fall into two buckets—fixed-rate mortgages and adjustable-rate mortgages (ARMs)—which differ in how interest is charged. A fixed-rate mortgage has interest that remains the same for the life of the loan, while an ARM’s interest fluctuates over time.

Understanding how each type of interest works and their benefits and downsides can help you determine which is best for your unique situation.

What Is a Fixed-Rate Mortgage?

A fixed-rate mortgage comes with a set interest rate for the entire duration of the loan (typically 15 or 30 years). The beauty of a fixed-rate home loan is that its locked interest rate guarantees your payments will remain the same as long as you have the mortgage. Not surprisingly, this type of mortgage is the most popular type of home loan with homeowners who prefer a predictable payment that is easy to budget for.

Advantages of a Fixed-Rate Mortgage

• Rates are more predictable: One of the most significant benefits of a fixed-rate mortgage is its predictability. From the moment you sign for your loan, you know exactly what your interest rate and monthly mortgage payment will be.
• Budgeting is easier: A steady interest rate simplifies your budget and provides unique benefits you may not find with an ARM.
• Comparisons are more straightforward: Comparing fixed-rate mortgages is simpler than comparing ARMs since you only have to evaluate rates and closing costs.

Disadvantages of a Fixed-Rate Mortgage

• Rates may be higher: Fixed-rate mortgages typically have higher interest rates than adjustable-rate loans, particularly in the initial years of the loan.
• It may be harder to qualify: With higher monthly payments in the initial years of the term, your lender may have more stringent requirements to ensure you can cover the larger payments.
• Interest rates may fall: Locking in a fixed rate when interest rates are low is a financially savvy move. Conversely, locking in a rate when interest rates are high can be very costly.

What Is an Adjustable-Rate Mortgage?

An adjustable-rate mortgage is a home loan that offers a low initial interest rate—usually lower than those for fixed-rate mortgages—for the first few years. Once this introductory period ends, the interest rate shifts to a “floating” rate that can change with market conditions.

Advantages of an Adjustable-Rate Mortgage

• Introductory interest rates are low: The biggest draw of an adjustable-rate mortgage is its low introductory interest rates, which are usually lower than fixed-rate mortgage rates.
• They may be less costly for short-term borrowers: Low ARM introductory rates are also attractive to borrowers who don’t plan to keep their properties for more than a few years.
• They’re easier to access with poor credit: While ARMs are riskier loans than fixed-rate mortgages, they typically offer an easier qualification process for those with less-than-ideal credit.

Disadvantages of an Adjustable-Rate Mortgage

• Rates are unpredictable: The biggest disadvantage of adjustable-rate mortgages is their unpredictable nature, which can be hard to budget for.
• They can be riskier than fixed-rate mortgages: If you stay in your home long enough, an ARM may cost you more in interest and monthly payments than a fixed-rate loan.
• They require a larger down payment: The minimum down payment on a conventional ARM is usually 5%, two points higher than the 3% baseline down payment on a conventional fixed-rate loan.

Fixed-Rate Mortgage vs. ARM Example

The introductory period of an ARM may feature a lower interest rate and payment than a fixed-rate mortgage, saving you money early on. But to effectively compare these two mortgage types, it’s essential to understand the maximum costs you could incur in either case.

To illustrate and compare each scenario, here’s a cost comparison on a $400,000 mortgage with a 2/1/5 cap schedule and the same amount in a fixed-rate mortgage. This 5/1 ARM comes with a maximum initial adjustment of 2% after five years, with subsequent annual 1% maximum increases up to a 5% lifetime adjustment cap. The ARM example assumes the rates increased by the maximum allowed.

Note: Estimates are for illustration purposes and are not a guarantee of rates and terms you may receive. For simplicity, the chart excludes costs for private mortgage insurance (PMI), taxes, HOA fees and more.

In this scenario, an ARM would cost you over $200,000 more than a fixed-rate mortgage if you held the home loan for the full 30-year term. However, if you sold your home during its introductory period or you refinanced to a fixed-rate mortgage, your overall expense may be less with an ARM.

Is It Better to Have a Fixed-Rate or Adjustable-Rate Mortgage?

Fixed-rate and adjustable-rate mortgages each have their own pros and cons, so deciding which is best for you may depend on your financial situation.

A fixed-rate mortgage may be best if:

• Interest rates are low: In a low-interest-rate environment, locking in a low rate can keep your payments lower over the term of your loan when rates eventually climb.
• You plan on staying in your home for the long haul: Fixed interest rates and payments make it easy to budget for your payment.
• You value lower overall costs: ARMs may be less expensive initially, but once your introductory period ends, rates can fluctuate up or down in response to market conditions.

While fixed-rate mortgages are a popular and generally safer choice for borrowers, there are situations where an ARM could benefit you, such as if:

• You only plan to live in the home for a few years: If you’re confident you’ll relocate before the fixed-rate period ends, an ARM could save you money.
• Interest rates are high: Since the introductory rate on an ARM is usually lower than on fixed-rate loans, it may help you afford a new home.

Check Your Credit Score Before Applying

Carefully consider the benefits and downsides of fixed-rate and adjustable-rate mortgages to help determine which might benefit you the most. In either case, you must meet your lender’s income and credit requirements to qualify. You’ll typically need a good credit score of at least 620 to qualify for a mortgage, but some loan programs may allow for a lower score.

Generally, the higher your credit score, the higher your odds of loan approval and securing a lower interest rate. Before applying for a fixed-rate or ARM mortgage, consider checking your credit report and credit score to see where you stand. Take steps to improve your credit if necessary to strengthen your position.