Choosing Between Fixed and Adjustable Rates

Buying a house is one of the most exciting and overwhelming things we do in our adult lives. Before you can move into a new space that’s all your own, you have to find a way to pay for it. Chances are, like most homebuyers, you’ll finance your home with a mortgage loan. And with that loan comes a few important decisions.

One of the first choices you’ll make is between a fixed-rate mortgage and an adjustable-rate mortgage. Each option has its own advantages, risks, and ideal use cases. So let’s break down how they work and how to decide which one could be right for you!

What is a Fixed-Rate Mortgage?

With a fixed-rate mortgage, your interest rate is set when you take out the loan and stays the same for the entire life of the mortgage. So, the main benefit is predictability.

While the amount allocated to principal and interest changes slightly over time, your total monthly mortgage payment for principal and interest does not change. Keep in mind, your taxes and homeowners insurance may change over time, which could affect your total housing payment. That can happen with both fixed and adjustable loans.

Another advantage is that fixed-rate loans are straightforward and easy to understand. They don’t vary much from lender to lender in structure. The downside is that the initial interest rate and payment may be higher than the starting rate of an adjustable-rate mortgage.

What is an Adjustable-Rate Mortgage?

With an adjustable-rate mortgage (ARM), the interest rate may go up or down over the life of the loan.

The main advantage is that the rate usually starts lower than a fixed-rate mortgage, which can mean a lower monthly payment in the beginning. The downside is that your rate, and potentially your payment, can increase later.

Typically, an ARM works like this:

• For a preset number of years, the interest rate remains the same.

• After that initial period, the rate adjusts at set intervals based on a financial index.

While this may sound risky, most of the “exotic” and dangerous adjustable loans that existed in the past no longer exist. Today’s ARMs are more conservative, regulated, and transparent. For the right borrower, they can be a smart and cost-effective option.

Depending on how long you plan to stay in your home, you could actually save money with an ARM!

Understanding the Initial Rate Period

The initial rate period is the length of time your introductory interest rate stays the same. This can range from one year to several years depending on the loan, with common examples like 5/1, 7/1, or 10/1 ARMs.

Expert Tip

Even if overall market rates stay steady, your rate and payment can still change once this initial period ends.

And the Adjustment Period?

Once the initial rate period is over, the interest rate begins to adjust at regular intervals. The adjustment period determines how often that change can happen.

For example, in a 5/1 ARM, the rate can adjust once per year after the first five years.

Interest Rate Caps and Why They Matter

Interest rate caps limit how much your interest rate can increase. This is an important layer of protection when choosing an adjustable-rate mortgage. There are three main types of caps:

• Initial adjustment cap: Limits how much the rate can increase the first time it adjusts.

• Periodic adjustment cap: Limits how much the rate can change from one adjustment period to the next.

• Lifetime cap: Limits how much the rate can increase over the entire life of the loan.

Caps help you better understand your worst-case scenario and plan ahead. If you’re comparing ARMs, it’s important to compare these caps, not just the starting rate.

Two lenders may offer the same initial rate, but very different caps.

Interest Rate Floors

While most borrowers worry about rates going up, some ARMs also include a “floor” rate. This is the lowest your interest rate can go, even if the market drops lower. In other words, your rate might not decrease beyond a certain point.

The Index and Margin

The fully adjusted rate of an ARM is made up of two parts:

• Index: A variable rate that follows the broader market, such as a U.S. Treasury rate.

• Margin: A fixed percentage set by the lender.

Your new interest rate equals the index plus the margin.

ARM example

Let’s look at a purely hypothetical 5/1 ARM:

• Loan amount: $300,000

• Initial rate: 3%

• Margin: 2%

• Index: 2.46%

• Caps: 5/2/5

This means:

• Your rate stays the same for the first 5 years.

• Your first adjustment can be no more than 5%.

• Future adjustments are limited to 2% at a time.

• Over the life of the loan, your rate can never rise more than 5% total.

So even if market rates jump dramatically, your interest rate will never exceed 8% due to the lifetime cap.

How to Choose Between Fixed and Adjustable Rates

Now that you understand the differences, here are a few questions to help guide your decision:

• What is your risk tolerance? Are you comfortable with the possibility of your rate and payment changing?

• Could your income handle the highest possible ARM payment if rates rise?

• Will you be taking on other large debts in the future?

• How long do you plan to stay in the home?

If you know you’ll only live in the home for five to seven years and you qualify for a 5/1 or 7/1 ARM, an adjustable-rate mortgage might be worth considering. If you plan to stay long-term and value stability, a fixed-rate mortgage may give you more peace of mind.