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Fixed & Adjustable Rate Loans
One of the decisions borrowers may face when choosing a mortgage is whether to select a fixed-rate mortgage or an adjustable-rate mortgage (ARM).
With a fixed-rate mortgage, the interest rate remains the same for the life of the loan. With an ARM, the interest rate can change after an initial period according to the terms of the mortgage.
Understanding how each option works can help you evaluate which structure fits your financial plans.
Fixed Rate Loan
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A fixed rate mortgage charges a set rate of interest that does not change throughout the life of the loan. Although the amount of principal and interest paid each month varies from payment to payment, the total payment remains the same, which makes budgeting easy for homeowners.
The main advantage of a fixed rate loan is that the borrower is protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise. Fixed-rate mortgages are easy to understand and vary little from lender to lender. The downside to fixed-rate mortgages is that when interest rates are high, qualifying for a loan is more difficult because the payments are less affordable.
Although the rate of interest is fixed, the total amount of interest you’ll pay depends on the mortgage term. Traditional lending institutions offer fixed-rate mortgages for a variety of terms, the most common of which are 30, 20, and 15 years.
The 30-year mortgage is the most popular choice because it offers the lowest monthly payment. However, the trade-off for that low payment is a significantly higher overall cost, because the extra decade, or more, in the term is devoted primarily to paying interest. The monthly payments for shorter-term mortgages are higher so that the principal is repaid in a shorter time frame. Also, shorter-term mortgages offer a lower interest rate, which allows for a larger amount of principal repaid with each mortgage payment. Thus, shorter term mortgages cost significantly less overall.
Adjustable Rate Loan
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The interest rate for an adjustable rate loan is a variable one. The initial interest rate on an ARM is set below the market rate on a comparable fixed-rate loan, and then the rate rises as time goes on. If the ARM is held long enough, the interest rate will surpass the going rate for fixed-rate loans.
ARMs have a fixed period of time during which the initial interest rate remains constant, after which the interest rate adjusts at a pre-arranged frequency. The fixed-rate period can vary significantly—anywhere from one month to 10 years; shorter adjustment periods generally carry lower initial interest rates. After the initial term, the loan resets, meaning there is a new interest rate based on current market rates. This is then the rate until the next reset, which may be the following year.
The biggest advantage of an ARM is that it is considerably cheaper than a fixed-rate mortgage, at least for the first three, five, or seven years. ARMs are also attractive because their low initial payments often enable the borrower to qualify for a larger loan and, in a falling-interest-rate environment, allow the borrower to enjoy lower interest rates (and lower payments) without the need to refinance the mortgage.
A borrower who chooses an ARM may save several hundred dollars a month for up to seven years, after which his or her costs are likely to rise. The new rate will be based on market rates, not the initial below-market rate. If you’re very lucky, it may be lower depending on what the market rates are like at the time of the rate reset.
The ARM, however, can pose some significant downsides. With an ARM, your monthly payment may change frequently over the life of the loan. And if you take on a large loan, you could be in trouble when interest rates rise: Some ARMs are structured so that interest rates can nearly double in just a few years.
Frequently Asked Questions Regarding Fixed
& Adjustable Rate Loans
Provided By Dovetail Mortgage: Your Loan Specialists in Braintree, MA
A fixed-rate mortgage has an interest rate that is established when the loan is originated and does not change during the loan term.
Because the interest rate remains fixed, the principal-and-interest portion of the mortgage payment remains predictable.
Property taxes, homeowners insurance, mortgage insurance, HOA expenses, and other costs are separate and may change even when the mortgage interest rate is fixed.
An adjustable-rate mortgage has an interest rate that may change over time.
Many ARMs begin with an introductory period during which the rate is fixed. After that period, the interest rate may adjust periodically according to the loan’s terms, generally based on an identified index plus a margin, subject to applicable adjustment caps.
The primary difference is what happens to the interest rate over time.
With a fixed-rate mortgage, the interest rate remains unchanged for the term of the loan.
With an ARM, the rate is typically fixed for an initial period and can then increase or decrease according to the loan terms and applicable index, margin, and caps.
The principal-and-interest payment on a traditional fixed-rate mortgage generally remains the same.
However, your total monthly housing payment can change if property taxes, homeowners insurance, mortgage insurance, escrow requirements, or other housing expenses change.
ARM terminology describes how long the initial interest rate remains fixed and how frequently the rate may adjust afterward.
For example, a 5/6 ARM generally has an initial rate period of five years, followed by potential adjustments every six months.
The exact adjustment schedule and terms are specified in the loan documents, so borrowers should review the specific ARM being offered rather than assume all adjustable-rate mortgages operate the same way.
The adjusted rate is generally determined using an index plus a margin, subject to the adjustment limitations contained in the mortgage.
The index is a benchmark identified in the loan documents. The margin is a specified number of percentage points added to the index. Rate caps limit how much the interest rate can change.
Rate caps limit how much an adjustable mortgage rate can change.
ARMs commonly have an initial adjustment cap, a subsequent adjustment cap, and a lifetime adjustment cap. These govern how much the rate can change at the first adjustment, at later adjustments, and over the life of the loan.
Depending on the loan’s terms and applicable index, an ARM rate may increase or decrease when it adjusts. However, floors, caps, margins, and other loan terms can affect the adjusted rate.
Borrowers should not assume that their rate will decline or that they will be able to refinance before an adjustment occurs.
Some borrowers consider ARMs because an available ARM may have a different initial rate than available fixed-rate options.
An ARM may be worth evaluating for borrowers who understand the potential payment changes and are comfortable with the risks associated with future adjustments.
The important consideration is not simply today’s initial rate—it is understanding what the interest rate and payment could become under the terms of the loan.
A fixed-rate mortgage offers predictability because the interest rate does not change over the life of the loan.
Borrowers who value consistency in their principal-and-interest payment or who expect to keep the mortgage for an extended period may want to compare fixed-rate options with available ARMs.
Potentially, yes. A borrower may refinance an adjustable-rate mortgage into a fixed-rate mortgage if they qualify and an appropriate loan program is available at that time.
However, refinancing is not guaranteed and generally involves qualification and closing costs. Borrowers should not select an ARM based solely on the assumption that they will be able to refinance before the interest rate adjusts. The CFPB specifically cautions consumers against making that assumption. Consumer Financial Protection Bureau
Consider questions such as how long you expect to own the home, how long you expect to keep the mortgage, your comfort with potential payment changes, your financial plans, and the actual terms of the loan options available to you.