In 2017, 1.24% mortgages wound up in delinquency. That number, down from 8.25% in 2009, represents a push to educate borrowers in the types of mortgages available as well as to regulate lenders.
Hopefully, there won’t be another housing bubble burst, but a mortgage can still go wrong if you don’t know what to expect. That’s why we created this adjustable rate mortgage vs fixed rate mortgage guide.
Keep reading to learn about each type of mortgage so you can make an informed decision about your future.
Adjustable Rate Mortgage Vs Fixed Rate Mortgage
There are actually more than these two types of mortgages, but as each type falls into adjustable rate mortgages (ARMs) or fixed rate mortgages (FRMs), we’re going to show you how each type works to get you started.
First-time home buyers, as well as those who have owned a home before, can benefit from this guide.
What Is An Adjustable Rate Mortgage?
These types of loans are just what they sound like–the rate can change over the term of the loan. The rate in question here is the interest rate, and how it can change is the key.
The initial interest rate is often below the market interest rate. Over time, the interest rate can fluctuate up or down depending on the benchmark.
A benchmark can be an asset like a certificate of deposit, or it can be an index like the Cost of Funds index.
The initial interest rate includes a margin, which is an extra percentage above the benchmark that you agree to pay. Your interest rate will stay the same for a period of three, five, or seven years. After that, it can start to change.
How often it changes depends on the adjustment frequency. This frequency can be set in intervals as short as one month or as long as ten years. This, along with all the other terms of your loan, will be set out at the beginning.
Typically, a shorter adjustment frequency results in smaller interest rate changes. However, ARM mortgage rates may have caps that stipulate the highest and/or lowest interest rate possible. Caps can also restrict the amount of change from one adjustment period to the next.
When caps specify the maximum monthly payment, the loan is known as a negative amortization loan. Where caps control the adjustments, a ceiling may specify the highest adjustable interest rate allowed for the life of the loan.
Adjustable Rate Mortgage Pros and Cons
The main advantage of securing an ARM is that payments start out lower because the interest rate is usually lower than with an FRM. In fact, an ARM can be cheaper for up to seven years. For homeowners who plan to sell within that time frame, an ARM vs fixed mortgage can save them a significant amount of money.
Often with an ARM vs. fixed, borrowers can qualify for larger loans because the initial payments will be lower. If interest rates are falling, borrowers can beat even the best fixed mortgage rates.
One of the cons of an ARM is that it’s far more complicated than a fixed rate mortgage. Another downside is the monthly payment can change over the life of the loan–and it can change frequently in some cases. If interest rates go up, homeowners can find themselves struggling to make ends meet.
What Is A Fixed Rate Mortgage?
Fixed rate mortgages are, like ARMs, aptly named in that the interest rate does not change–throughout the life of the loan.
Some borrowers may become confused because the number of their monthly payments that go toward interest versus principal can change, but the interest rate and their monthly payments remain the same. This is because, with an FRM, borrowers tend to pay more interest first.
In other words, you’re paying for the opportunity to borrow the money before you’re paying back the money. That’s why FRMs are great for borrowers who plan to stay in their home for a long time. It can take time to get into buying into the equity of the property.
Unlike ARMs, FRMs don’t vary much from lender to lender because the rates they offer are based on industry rates.
Fixed rate mortgages are generally offered in 30-year, 20-year, and 15-year terms. 61.49% of all mortgages are 30-year FRMs. The reason the 30-year FRM is so popular is that of all FRMs, it offers the lowest payment. Ultimately though, the 30-year is the most expensive of the FRMs since borrowers will pay more in interest due to the longer loan term.
Fixed Rate Mortgages Pros and Cons
FRMs are often popular because they’re easy to understand. There’s a principal, a constant interest rate, and a term of the loan. Those three factors determined the monthly payment.
Because the monthly cost never wavers, FRMs make for easy budgeting. For first-time homebuyers, this can be a huge draw because of all the other variable costs that accompany home ownership.
The main benefit of an FRM is even if interest rates soar, the borrower is protected from having to pay those rates. Of course, the downside is if market interest rates plummet, the borrower is stuck paying the fixed rate.
In times when interest rates are high, FRMs are more difficult to obtain because payments will be larger. This means borrowers seeking an FRM in a high-interest environment need to have better credit scores, higher salaries, lower costs of living, or choose homes that don’t cost as much.
Conclusion: Adjustable Rate Mortgage vs Fixed- Which One Is Right For You?
Before choosing which type of mortgage will best serve your needs, you need to assess your priorities and how long you think you’ll live in your new house. These will be the determining factors in whether you choose an ARM or FRM.