When shopping around for a mortgage loan, you will undoubtedly come across two frequently used terms: Fixed rate and ARM.
Fixed rate and adjustable rate mortgages are the two most common types of home loans, but do you know the difference between the two? If not, you may not be sure which one is best. Compare the following pros and cons of each to determine whether a fixed-rate mortgage or adjustable rate mortgage is better for you.
Fixed Rate Mortgage Definition
A fixed rate mortgage is often referred to as a “conventional” mortgage. They are generally the most common type of mortgage for first-time home buyers. This is because the interest payment on a fixed-rate mortgage is set at the beginning of the loan and remains the same for the entire term (hence the name). Thus, payments are more stable and predictable than other types of mortgages.
Pros of a Fixed Rate Mortgage
- Protection against rising rates. If interest rates increase, the mortgage payments do not.
- Planning made easy. Since borrowers will make the same interest payments every month, a fixed mortgage allows you to plan your expenses and budget well into the future.
Cons of a Fixed-Rate Mortgage
- Possibility of paying more. Even though you are protected against rising rates, you may also be stuck paying higher interest if rates decline. If interest rates remain low for the majority of your loan term, you may end up paying more in interest than others with adjustable rate mortgages.
- Payments still not set in stone. The interest payment may never change, but the total amount you pay every month can fluctuate according to changes in taxes and insurance.
Adjustable Rate Mortgage (ARM) Definition
An ARM is a type of home mortgage with an interest rate that fluctuates over the term of the loan. The rate often adjusts according to changes in the prime rate or Treasury bill rate. An ARM usually starts with an interest rate that is lower than most fixed-rate mortgages, though this tends to change as time goes on.
Pros of an ARM Mortgage
- Initial interest and payments are often less than a traditional mortgage loan, especially if interest rates in general remain low.
- You may be able to qualify for a larger loan amount if you know your income will increase in the future.
Cons of an ARM Mortgage
- Payments can become unaffordable if interest rates rise significantly.
- There is an annual interest cap put in place to protect the borrower from such a scenario. However, the cap doesn’t apply to the first interest adjustment, which also happens to be the most expensive in most cases.
Which One is Better: Fixed-Rate or Adjustable Rate?
The ability to predict the future is required to fully answer this question. A fixed-rate mortgage is best when interest rates are high or especially volatile. Adjustable rate mortgages can be most advantageous when interest rates are low.
Since there is no way to know what interest rates will do months or years from now, determining which type of loan is best suited for you depends on your personal preference.
Do you want a stable, reliable interest payment for the entire term of your loan? Do you want a long-term loan without much risk? A fixed-rate mortgage is probably best for you.
Are you instead looking to take advantage of low interest rates on a shorter-term loan? If you are willing to risk making higher interest payments in the future to possibly save money overall, consider an adjustable rate mortgage.