Comparing Fixed-Rate And Adjustable-Rate Mortgage Loans

By Angela Stringfellow. May 7th 2016

Making the leap into homeownership comes with a lot of decisions. One of the biggest decisions is figuring out what type of interest rate your mortgage will have. Since most lenders offer both fixed-rate and adjustable-rate mortgages, you will need to decide which type of mortgage works best for you. There are some unique advantages and disadvantages to each type of mortgage. Therefore, before making a final decision, you should carefully consider the pros and cons of each.

Fixed-Rate Mortgages

One of the most popular options in mortgage lending is the fixed-rate loan. Fixed-rate loans have an interest rate that remains constant throughout the life of the loan. Many homebuyers opt for a fixed-rate mortgage so that they will not have to worry about rising interest rates causing their monthly mortgage payments to balloon throughout the life of the loan.

Because they do not adjust with market conditions, fixed-rate mortgages tend to be most attractive to homebuyers when interest rates are low.

Most lenders offer 15- or 30-year fixed-rate mortgages. There are some distinct advantages and disadvantages to both.

15-Year Fixed Rate Mortgage

Homebuyers often choose the 15-year option because they are able pay off the loan in less time while paying considerably less in overall interest payments. Additionally, homeowners are able to build equity in their homes quickly because of the shorter amortization schedule. The downside with 15-year mortgages is that the monthly mortgage payments are generally 10 to 15 percent higher than those of a 30-year mortgage.

30-Year Fixed-Rate Mortgage

Homebuyers electing a 30-year fixed rate mortgage are able to borrow money on a long-term basis while taking advantage of consistent interest rates. Because of the length of the loan, the monthly mortgage payments could be lower than those of a 15-year loan depending on the interest rate. The downside of 30-year mortgages is that homeowners are subjected to higher overall interest payments compared to 15-year loans. In addition, due to the longer amortization schedule, it takes homeowners longer to build equity when compared to a 15-year payment schedule.

Adjustable-Rate Mortgages

An adjustable-rate mortgage (ARM) is a mortgage that has a variable or unfixed interest rate. A variable interest rate fluctuates based the prevailing market conditions.

ARMs offer homebuyers a lower initial interest rate compared to fixed rate loans, which provides lower monthly payments and enables homebuyers to qualify for larger loans.

However, after the initial fixed-rate period set by the terms of the loan expires, the interest rate becomes variable. If interest rates rise, so do the monthly mortgage payments. Conversely, if interest rates fall, the mortgage payment does as well. Therefore, ARMs allow for both higher and lower mortgage payments depending on the prevailing interest rates.

It is important to note that there are some mechanisms which help to protect people who invest in an ARM from interest rate volatility. Caps can be put in place to limit the increase in rates helping protect homeowners from skyrocketing payments. These caps include:

Initial Rate Cap: This cap limits the interest rate increase for the first scheduled adjustment. This protection is an optional feature on ARMs.

Periodic Rate Cap: This cap limits the increase in interest rates from one adjustment period to the next. This is also an optional cap that can be added to the loan.

Overall Caps: Required by law since 1987, this cap limits how much the interest rate can increase over the life of the loan.

Fixed-Rate Mortgages Vs. ARMs

Many lending companies offer mortgage calculators that examine the terms of a loan and calculate estimated monthly payments. Utilizing these calculators can help homebuyers make an educated decision on which type of mortgage they are comfortable with and can afford.

The bottom line is that if you are risk averse, you should probably opt for a fixed rate mortgage to eliminate your exposure to interest rate volatility. However, if interest rates are high and you have some risk appetite, you might consider getting an ARM. Remember that you can refinance from one type of loan into another. You might consider doing this if you think you can save money or if you made a mistake about which type of loan is right for you. However, remember that there are risks to refinancing. (For more information, see Reasons Not To Refinance Your Mortgage.)

Homeownership is rewarding for many people. However, in order to do it the right way, it is critical to do the appropriate amount of research on all of your options. Utilize the resources available and ask questions of the mortgage broker. Read the fine print and know what to expect throughout the life of the loan. This will ensure that you get the best mortgage for your financial situation.

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