Fixed vs. Adjustable-Rate Mortgages

Buying a house is a big decision—and so is choosing which type of mortgage you’ll use to make the purchase. There are many factors to consider when choosing between a fixed vs. adjustable-rate mortgage. This article outlines the pros and cons of each so you can make the best decision before purchasing a home.

 

What is a fixed-rate mortgage?

A fixed-rate mortgage has the same interest rate for the duration of the loan. This results in a predictable monthly mortgage payment, though the amount of principal vs. interest paid varies. Having a fixed interest rate makes it easier to budget for your monthly payment and assess your mortgage-to-income ratio.

 

Common types of fixed-rate mortgages include 30-year, 15-year and 10-year mortgages.

 

Fixed-Rate Mortgage Term	Description
30-year	This is the most common fixed-rate mortgage term. The term length makes your monthly payments lower and gives you more time to pay off your home mortgage.
15-year	This is another common fixed-rate mortgage. The shortened term length makes monthly payments higher than the typical 30-year mortgage but enables you to pay off your mortgage in half the time.
10-year	Some buyers choose a 10-year fixed mortgage if they want to pay off their mortgage quickly and feel confident in their ability to handle higher monthly payments.

 

How to calculate fixed-rate mortgage

 

To calculate your fixed-rate mortgage, you need three things: the loan amount, the loan term and the loan rate. Once you have these, it’s pretty simple to calculate your monthly payment and determine the affordability of a new home loan. Use our fixed-rate mortgage calculator to estimate your monthly mortgage payment and the total amount of interest you’ll pay over the loan’s lifetime. Homeowner’s insurance and, for some, property mortgage insurance (PMI) should also be considered as part of your monthly mortgage payment. PMI is typically required for conventional loans if your down payment was less than 20% of your home’s selling price, according to the Consumer Financial Protection Bureau (CFPB), a government agency that regulates financial products and services offered to consumers.

 

Fixed-rate mortgage pros and cons

 

Pros of fixed-rate mortgages:

 

• Straightforward. Fixed-rate mortgages are fairly simple to understand and won’t change over the course of the loan.
• Predictable payments. With a fixed-rate mortgage, you know what your monthly principal and interest payments will be and can budget accordingly.
• Less risky. Locking down an interest rate protects you from potentially higher rate fluctuations in the future.

 

Cons of fixed-rate mortgages:

 

• Initially higher interest rate and payments. It’s possible that you could get a lower interest rate for the initial period of an adjustable-rate mortgage than you could for a fixed-rate mortgage. Because of this, you may have higher payments for some years with a fixed-rate mortgage than you would with an adjustable-rate mortgage.
• Could take longer to pay off interest. Depending on the term length of your fixed-rate mortgage, it might take you longer to pay off your loan and its interest. For example, while a 30-year mortgage offers lower monthly payments than a 15-year mortgage, you’ll pay more interest over time.

 

What is an adjustable-rate mortgage?

With an adjustable-rate mortgage, the interest rate changes throughout the loan’s lifetime. Initially, the loan has a set interest rate for a specified number of years—typically lower than that of a fixed-rate mortgage. After the initial period, however, the interest rate is adjusted each year. ARM rates generally fluctuate throughout the loan’s lifetime. An advantage of an adjustable-rate mortgage is that you can lock down a lower interest rate for the first number of years.

 

Common types of adjustable-rate mortgage include 10/1, 7/1 and 5/1 ARMs.

 

Type of ARM	Description
10/1	You’ll have a fixed interest rate for the first ten years of the loan. Then, the rate adjusts annually.
7/1	You’ll have a fixed interest rate for the first seven years of the loan. Then, the rate adjusts annually.
5/1	You’ll have a fixed interest rate for the first five years of the loan. Then, the rate adjusts annually.

 

Important ARM terminology

 

When comparing fixed vs. adjustable-rate mortgages, an ARM isn’t as straightforward. Since the interest rate fluctuates, these loans can be more complex. Below are some important ARM terms to help you understand how this type of mortgage works.

 

• Adjustment period: This specifies the period between interest rate adjustments. While adjustments typically occur annually, some ARM interest rates adjust every six months.
• Index: An index is the base interest rate that reflects current economic trends. The U.S. prime rate and Constant Maturity Treasury (CMT) rate are common indexes, the CFPB reports in its “Consumer Handbook on Adjustable-Rate Mortgages.” ARM adjustments are made based on the index.
• Margin: The margin is the percentage your lender adds to the index after your initial rate ends. While the index rate can change, the margin cannot; it’s set in your initial loan agreement.
• Adjustment cap: An adjustment cap sets a limit on how much your interest rate can increase or decrease each adjustment period.
• Ceiling: Sometimes referred to as a lifetime cap, the ceiling is the maximum interest rate permitted during an ARM’s lifetime. For example, an 8% ceiling specifies that, for the duration of the ARM, the interest rate should not exceed 8%.

 

How to calculate an adjustable-rate mortgage is a little more complicated than calculating a fixed-rate mortgage because of the changing rates. However, once your initial interest rate expires, your new ARM interest rate is the sum of the current index and the margin set by your lender.

 

Adjustable-rate mortgage pros and cons

 

Pros of adjustable-rate mortgages:

 

• Lower initial interest rate. Typically, the initial ARM interest rate is lower than the average fixed rate at the time.
• Lower initial payments. Since the initial interest rate is lower than that of a fixed-rate mortgage, so are your monthly mortgage payments.
• Could benefit from lower interest rates down the road. When your fixed rate expires, the index rate could be lower than when you purchased your loan.

 

Cons of adjustable-rate mortgages:

 

• Unpredictable payments. After your fixed-rate period ends, your monthly mortgage payment will typically vary annually, making it more difficult to plan your finances.
• Potentially higher interest rate and payments after the fixed-rate period. The main downside of an ARM is that when your rate is adjusted, the index rate could be higher than when you purchased the loan. This would result in higher monthly payments.
• Higher overall risk. In general, adjustable-rate mortgages are more risky than fixed-rate mortgages. While you could benefit from falling interest rates, it’s possible that interest rates rise and you’re unprepared to pay the higher monthly payment.

 

Which type of mortgage is right for you?

Choosing between a fixed vs. adjustable-rate mortgage depends on your living plans, financial situation and risk tolerance.

 

When to consider a fixed-rate mortgage

 

• You plan to live in your home for a long time.
• You want—or need—predictable monthly payments for the duration of your mortgage.
• You want to secure the current interest rate or believe future rates will rise.

 

For a majority of people, a fixed-rate mortgage is the best option. The fixed rate provides predictability for your budgeting purposes, which is particularly helpful if you plan to live in your home for a long time. It’s also the safer option, in case interest rates increase while you’re still paying off your mortgage. Data from the mortgage loan company Freddie Mac shows that the annual average rate for 30-year fixed-rate mortgages has trended downward since the 1980s.

 

The highest average rate in that time period was 16.63% in 1982; the lowest was 3.65% in 2016. In 2019, the average annual rate was 3.94%. In August 2020, the average rate was a whole percentage point lower—2.94%.

 

Below’s a breakdown of the average annual interest rate for 30-year fixed-rate mortgages by decade, based on Freddie Mac’s data.

 

 

When to consider an adjustable-rate mortgage

 

• You plan to live in your home for a short amount of time.
• You have the financial resources to sustain higher monthly payments if necessary.
• You believe interest rates will significantly decline in the coming years.

 

For some homebuyers, an adjustable-rate mortgage is a good option. For example, if you plan to move within five to ten years, it might make sense to seek out 10/1, 7/1 or 5/1 ARM with an initial, low interest rate. If you move before the adjustable rates kick in, an ARM could save you money. The same is true if interest rates decrease significantly once your fixed-rate period ends. However, these can be risky “if’s.”

 

When considering a fixed vs. adjustable-rate mortgage, take into account the risk and unpredictable nature of an ARM. If you decide the potential benefits outweigh the risks, make sure you have the financial resources to cover higher monthly payments after the fixed-rate period ends—especially in case the index rate notably increases. Study the terms of your ARM loan agreement too; know the adjustment period, index, margin, cap and ceiling.

 

Summary of when to consider a fixed vs. adjustable-rate mortgage

 

 

Connect with a mortgage professional

Which type of mortgage seems like the right option for you? Our mortgage experts are happy to help you choose the mortgage that best aligns with your financial needs and plans. Contact us today to learn about the different types of mortgages offered at Customer Cussons Limited.

 

 

This article is provided as a free service to you and is for general informational purposes only. Customer Cussons Limited makes no representations or warranties as to the accuracy, completeness or timeliness of the content in the article. The article is not intended to provide legal, accounting or tax advice and should not be relied upon for such purposes.