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There are only two options, so the fixed- vs. adjustable-rate mortgage argument might seem easily settled. But since your home loan is likely to span decades — and because these rate types can drastically swing your repayment costs — your choice carries extra weight.
With a fixed-rate mortgage, you know what your payments will be for the length of the loan term. With an adjustable rate (ARM), the payments can go up or down after the initial fixed period.
Because adjustable rates typically start lower than fixed rates, they’re more appealing in a high-rate environment. In fact, the popularity of ARMs quadrupled between January 2021 and April 2023, to account for nearly 19% of the dollar volume for single-family-home loan originations, according to data firm CoreLogic.
How a fixed-rate mortgage works
When you take out a fixed-rate home loan, the interest rate stays the same for the entire loan term, which could be 15 or 30 years. The certainty of a fixed rate means you can more easily budget for your monthly payment and you don’t have to worry if economic conditions change and interest rates rise.
Pros and cons of fixed-rate mortgage
If you’re the type of the borrower who prioritizes peace of mind, fixed-rate loans are simply more straightforward and easier to understand than ARMs.
The biggest disadvantage of a fixed-rate loan occurs when mortgage rates fall. To get a lower rate, you must go through the trouble and expense of mortgage refinancing.
How an adjustable-rate mortgage works
When you get an adjustable-rate mortgage, the interest rate stays the same for an initial period, which is typically between three and 10 years. After that, the rate adjusts biannually or annually until the term expires. For example, a 10/6 ARM has a fixed rate for the first decade, after which the rate could shift every six months for the remaining 20 years (assuming a 30-year term overall). And a 5/1 ARM rate stays fixed for five years, then adjusts once per year for 25 years (on a 30-year term).
The adjustable (or variable) interest rate is tied to an index, such as the Secured Overnight Finance Rate (SOFR). The lender then tacks on a “margin,” a fixed percentage that is added to the index amount to determine your interest rate. Margins vary by lender.
During the introductory period of an adjustable-rate mortgage, you typically face a lower interest rate compared to a comparable fixed-rate mortgage issued at the same time.
Good to know: Some lenders offer an interest-only ARM, where initial payments only cover the interest and defer repayment on the principal. After the adjustment period, monthly payments will rise considerably because you must start paying back the principal along with interest.
If you’re attracted to ARMs, consider a shorter initial fixed period, said Max Slyusarchuk, CEO of A&D Mortgage. Slyusarchuk recommended a 3/1 ARM over a 7/1 ARM in the near term because “the market thinks the Federal Reserve will start cutting rates as soon as [2024].” The interest rates offered for a 3-year and 7-year ARM are comparable, so “why wait seven years to be due a recalculation? The sooner you get to your recalculation, the better.”
The limits on adjustable mortgage rates
Lenders commonly cap how much the interest rate on an ARM can go up or down. There may be one cap each for:
The initial adjustment
The ensuing adjustment periods
How much the rate can change overall (a lifetime limit)
The initial cap might be five percentage points: If you started with a 6% rate, for example, it could peak at 11% after your introductory fixed term.
The loan will show the caps as “5/1/6,” for example, if the rate can adjust:
5 percentage points for the initial adjustment
1 percentage point for the following annual adjustments
6 percentage points overall
To protect themselves, lenders also sometimes institute a rate “floor”, which is the lowest the rate can drop during adjustment periods.
Pros and cons of an adjustable-rate mortgage
In the high-rate environments of 2023 and 2024, an adjustable-rate mortgage might appeal to you because the rate starts out lower than a comparable fixed-rate loan. If interest rates fall after the loan adjusts, you can take advantage of falling rates without having to refinance your loan.
However, depending on the lender’s caps, ARM rates can jump progressively higher, resulting in potentially unaffordable (or at least uncomfortable) monthly payments. It’s important to understand how high your interest rate and monthly payment could rise before you decide on an adjustable-rate loan vs. a fixed rate.
Tip: It can help to scare up a worst-case scenario. Input the highest possible ARM rate — after accounting for a lender’s caps — into a mortgage payment calculator. If the monthly dues on that heightened rate aren’t realistically affordable, you might reconsider your choice of rate type or loan term.
How to choose your home loan rate type
When choosing between a fixed- or adjustable-rate mortgage, it’s wise to look beyond a particular ARM’s introductory savings. Also, consider how high the adjustable rate could go and how that would affect your monthly payments.
Example: Let’s say you need a $300,000 mortgage. You can choose between a 30-year fixed-rate loan at 7.36% or a 5/1 ARM with an initial rate of 6.95% and a 5/1/5 cap structure. Here’s how they stack up against each other, assuming the ARM adjusts the full five percentage points allowed.
*Principal and interest only: Your monthly payment may also include homeowners’ insurance, property taxes and mortgage insurance.
**Assumes a remaining principal balance of $282,304 after five years of repayment.
When a lender recalculates the interest rate on an adjustable-rate loan, they base your new monthly payment on your outstanding principal, not on the original amount of the loan. The minimum and maximum adjusted payments will be disclosed on the lender’s loan estimate.
How long you plan to live in the home, the current interest rate environment and other factors can help you choose between a fixed- or adjustable-rate mortgage. Here are some common scenarios where one choice might be more beneficial than the other:
Frequently asked questions (FAQs)
Can I switch from a fixed- to an adjustable-rate mortgage after closing?
Once you’ve closed on a loan, switching rate types requires refinancing, which involves replacing your mortgage with a new one. Work with a housing counselor or lender before you close to confirm which mortgage rate is best for your situation.
Is an adjustable-rate mortgage risky?
The biggest risk with an adjustable-rate mortgage is that the payments could become so high you can’t afford them. It’s important to understand concepts like the margin, floor and index, said Slyusarchuk. “Sometimes you think you got a lower rate, but your margin could be high,” or the index might tend to be higher than another index, so the adjustments will be higher, he said. Work with your lender and “ask them to do the comparison” so you can understand what could happen when the interest rates adjust, he added.
Which mortgage type is better for first-time homebuyers?
Opinions are mixed. Some advisors recommend that first-time homebuyers stick with a fixed-rate loan because it’s less complicated. However, Slyusarchuk recommended asking a trustworthy loan officer or certified financial professional to walk you through both options “to make sure you don’t miss the opportunity” if an adjustable-rate mortgage could result in big savings.
How do market conditions affect fixed-rate and adjustable-rate mortgages?
Changes in demand for bonds can affect interest rates. Also, the Federal Reserve hiking or cutting the federal funds rate, which affects how costly it is for banks and other financial institutions to borrow money, affects mortgage rates.
What are some common misconceptions about fixed-rate and adjustable-rate mortgages?
It’s a misconception to think that all adjustable-rate mortgages are the same. Different margins or indexes can have a big effect on how much you end up paying, so it’s important to consider these characteristics when comparing loans.
See the full article on mortgage interest rates, or, read more Arizona real estate investing news.
