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There are many factors to consider as you shop around for a mortgage loan for your home purchase—and one of the most important is how to handle your loan's interest rate. Your options fall into two buckets, fixed-rate mortgages and adjustable-rate mortgages, which differ by whether the interest rate is set for the lifetime of the loan or changes over time.
Each loan type has advantages and disadvantages, and your decision on which one works best for you will depend on several factors. Before we dive into the specifics, here's how each loan type is defined:
- A fixed-rate mortgage has a set interest rate for the entire duration of the loan (typically 15 or 30 years). It's a type of installment loan, similar to a student loan or personal loan, with fixed monthly payments.
- An adjustable-rate mortgage (ARM) has an interest rate that can change during the course of the loan. It starts with a temporary introductory interest rate that's typically lower than those available on fixed-rate mortgages. But when this introductory period ends, the interest rate shifts to a "floating" rate that can change with market conditions.
How Do Adjustable-Rate Mortgages Work?
The nuances of how and when ARM rates adjust vary from loan to loan, but when they change, they almost always bring an increase in monthly payments. It's critical to read your loan agreement carefully before signing to make sure you understand all the specifics. These are variables to bear in mind when comparing adjustable-rate mortgages:
- The length of the introductory period: Five-year introductory periods on 30-year loans are common, but one-, three- and seven-year introductory periods are all possible.
- The index to which the floating rate is tied: Indexes commonly used to set ARM rates include the yield on one-year constant-maturity Treasury (CMT) securities, the Cost of Funds Indices (COFI), and the London Interbank Offered Rate (LIBOR), which will be eliminated in 2021 but is still widely used to set ARM rates.
- The margin added to the index to determine the rate you pay: The margin is a fixed percentage specified in the loan agreement. Margin ranges vary for different indexes (2% to 3% with the LIBOR is fairly common, for example). The lower the margin, the better the loan terms are for you because even a small percentage point difference can drastically change the cost over the life of a 30-year mortgage.
- Rate adjustment frequency: Once the introductory period ends, the rate on an ARM resets at regular intervals. Once a year is common, but two- and three-year periods may also be used, and some ARMs reset every six months. On the reset date, a new rate is calculated by adding the margin to the value of the index on that day; the new rate applies until the next reset date.
- Rate caps: To prevent extreme increases in ARM rates, ARMs typically limit the amount their interest rates can increase. A periodic cap limits the amount the rate can increase from one adjustment period to the next, while a lifetime cap limits the total amount the rate can ever increase over the introductory rate. Some ARM loan agreements also specify payment caps—limits on the amount your monthly payment can rise each readjustment period.
When comparing mortgage offers, you'll often see shorthand that summarizes interest rate, introductory period and rate-adjustment frequency: A 3.8% 5/1 ARM, for instance, has an introductory period of five years, after which it resets every year, while a 3.75% 3/2 ARM has a three-year introductory period, after which the rate resets every two years. For more details on the ins and outs of ARMs, the Federal Reserve offers a very thorough handbook.
The Pros and Cons of Adjustable-Rate Mortgages
Before you take out an adjustable-rate mortgage, make sure you understand both the benefits and downsides.
Low Introductory Interest Rates
A big appeal of an adjustable-rate mortgage is its low introductory interest rate. ARM intro rates are typically lower than the rates for competing fixed-rate loans. The low rates can offer more manageable monthly payments that may appeal to younger borrowers early in their careers who expect their earnings to track with, or outpace, the rate increases to come once the ARM's introductory period ends.
Low ARM introductory rates are also attractive to borrowers who don't plan to keep their properties for more than a few years. Selling a home before an ARM's introductory rate expires is a common tactic, and many ARM loan agreements discourage it by including stiff prepayment penalties. Of course, this strategy can also backfire if the local real estate market stalls or takes a downturn, making it difficult to sell the property.
Rates Are Unpredictable
The biggest disadvantage of adjustable-rate mortgages is their unpredictable nature. Increases in monthly payments every adjustment period can put major stress on household budgets. In climates where interest rates are increasing steadily, an ARM with a payment cap can even put you in a situation known as negative amortization, in which you make your payments in full, but actually owe more money each month. Of course indexes can also decrease, bringing some relief in terms of payment amount—but not in terms of long-term predictability.
May Be More Readily Available to Those With Poor Credit
Bearing these risks in mind, one of the biggest appeals of ARMs may be that borrowers with limited or poor credit histories may have a better chance of getting one than they would a fixed-rate loan. ARMs are the most common type of subprime mortgages, but their initial affordability and availability also makes them popular among borrowers with fair to good credit.
How Do Fixed Rate Mortgages Work?
A fixed-rate mortgage is the most popular type of mortgage loan, and its interest rate stays the same for the entire life of the loan. These loans most often come in 30-year terms, but you can also find them with terms of 10, 15 or 20 years. The shorter the term, the lower the interest rate—but the higher the monthly payment since the loan is repaid in a more compact time frame.
Pros and Cons of Fixed-Rate Mortgages
Here are a few of the benefits and drawbacks to be aware of as you consider fixed-rate mortgages.
A major advantage of a fixed-rate mortgage is predictability. When your interest rate is set, you know from day one how much your mortgage payment will be each month. This is less risky than an ARM, whose rate can go up after the introductory period.
The certainty of a consistent interest rate simplifies household budgeting, lets you anticipate how much mortgage interest you'll be able to deduct each year on your income tax return, and makes it possible to do long-term planning for paying off the mortgage. For instance, you can calculate the amount you'll spend over the life of the loan, and then determine how much you can expect to save if you pay off the loan early.
May Be Difficult to Qualify For
Fixed-rate mortgages can be harder to qualify for than ARMs. If your credit is in great shape, you may have no issue qualifying for a fixed-rate loan. But if your credit needs improvement, you may find it easier to qualify for an ARM, which may be more lenient with credit history.
Locked In if Interest Rates Fall
Like all interest rates, mortgage rates rise and fall with market conditions. U.S. interest rates have been remarkably low over the past decade, and mortgage rates have largely followed suit. If you can nab a low rate when you take out your loan, this will be beneficial in the long run.
However, if you lock in a 30-year fixed-rate loan during a period of high interest rates, it can be very costly. If interest rates go down significantly, it may be possible to refinance a high interest loan by taking out another mortgage at a lower rate, but fees and services involved in that process can cost thousands of dollars. It may be worthwhile to save tens of thousands of dollars over the life of the loan, but it's still a major expense.
How to Choose Between an Adjustable-Rate and Fixed-Rate Mortgage
Here are a few questions to ask yourself as you decide whether an adjustable-rate mortgage or fixed-rate mortgage makes the most sense for your home purchase.
- How long do you plan on living in your home? As mentioned, ARMs often work best for those who don't plan to stay in the home for more than a few years, since you'll get to spend some or all of the time paying the low introductory rate and avoiding the probable higher rate that will kick in later. If you plan to be in the home for the long term, a fixed-rate APR may be best since it will remain predictable.
- What do current interest rates look like? When mortgage rates are on the high side, getting locked in to a fixed-rate loan could be expensive (though you may be able to refinance later). In that case, the risk of an ARM could be worth it since the introductory rate will be lower than fixed-rate loans. On the other hand, if mortgage rates are currently low, it could be a great time to lock down a fixed-rate loan since future market changes won't impact you.
- Will you be able to afford payments if interest rates rise? The beauty of fixed-rate mortgages is the predictability of your monthly payments. If you're on a tight budget, this certainty can help you stay on track. While ARMs start off with a lower rate, they can rise later, which would increase your monthly payment. Consider how flexible your budget is (or isn't) and whether you'd be able to afford a higher mortgage payment if interest rates go up.
Know Your Score Before You Apply
While mortgage rates are largely determined by market conditions, your credit score also plays a big role. Having good credit increases your chances of qualifying for a mortgage and getting the best interest rate. If you haven't taken a look at your credit report lately, check your credit for free on Experian to see where you stand. You may see some room for improvement that you can work toward before applying for a mortgage, whether fixed-rate or ARM.