What’s the Difference Between Fixed-Rate and Adjustable-Rate Mortgages?
Point of Interest
Understanding different mortgage options is a key factor in buying a home. Interest rate structures, credit score requirements and loan terms can all differ between fixed-rate and adjustable-rate home loans.
Out of all the money moves you can make, buying a home might be the most daunting — but also the most doable. In fact, more Americans currently own their home rather than renting, with the current U.S. homeownership rate at 65.3%. There are tons of different types of mortgages, interest rates and term lengths to choose from when buying a home. Choosing the right type of mortgage can set you up for a great start when house shopping. Two types of mortgage loans — fixed and adjustable-rate — offer low interest rates and different benefits for potential homeowners, but how do you know which works best for you?
How mortgages work
A mortgage is a loan designed specifically for buying a home. A borrower can take out a mortgage and then pay it back with monthly payments over the course of a set number of years.
Mortgages are a form of secured loan in which the house acts as collateral. This means that in the worst-case scenario, the lender could take possession of the house through foreclosure if a borrower does not make monthly payments. Maintaining a mortgage can be a complicated process, so it’s essential to have a grasp of the different options available.
There’s a wide variety of lenders out there and credit or other loan requirements vary widely by lender, as will the requirements for each type of loan. For example, fixed-rate mortgages often require a higher credit score than adjustable-rate mortgages due to the higher monthly payment. But, even aside from credit requirements, there are many differences between fixed and adjustable-rate mortgages.
What is a fixed-rate mortgage?
A fixed-rate mortgage offers a set interest rate that stays the same throughout the mortgage term. Your monthly payments will remain predictable and steady from month to month. Fixed-rate mortgages are usually considered safer investments since the interest rate doesn’t fluctuate, which means you know what to expect with each payment and can plan for it.
However, it can be slightly more difficult to qualify for a fixed-rate mortgage than some other types of mortgages. Lenders decide if you have enough income to make your monthly payments based on the initial interest rate, which is usually higher for a fixed-rate mortgage. Borrowers pay a higher monthly payment with a fixed-rate mortgage from the start, whereas adjustable-rate mortgage payments start with lower interest rates and have the potential to increase with time.
Tip: Fixed-rate mortgages tend to have longer loan terms, with most being 15-year or 30-year periods.
Pros of fixed-rate mortgages
- The interest rate will never fluctuate, meaning you always know what to expect.
- Borrowers are protected from rising interest rates.
- They’re typically much less complicated than adjustable-rate mortgages.
Cons of fixed-rate mortgages
- Fixed interest rates are often higher than the starting adjustable rate.
- Borrowers won’t benefit if interest rates drop.
- It can be more difficult to qualify due to higher initial payments.
What is an adjustable-rate mortgage?
An adjustable-rate mortgage, or ARM, is a mortgage loan that starts with a fixed interest rate for a period of time, and once that set period is over, the interest rate can go up or down periodically. This means that the initial interest rate may be lower for a set period of time, typically three to seven years from the start of the loan. However, the rate will vary after this time is up, meaning monthly payments could increase if interest rates increase. This can potentially make it more difficult to budget and plan ahead financially.
However, there are many options for adjustable-rate mortgages that can make them useful in the short-term. For example, with a 5/1 mortgage, the interest rate would stay the same for the first five years and then increase once per year. If you were not planning to own a particular home for more than five years, you could take out a 5/1 ARM and never have to deal with a change to the interest rate.
Tip: There’s more to interest rates than just your credit score. Inflation, monetary policy, and the overall housing market can affect how rates increase or decrease each year once the initial loan term ends.
Pros of adjustable-rate mortgages
- Initial interest rates are typically lower than rates for fixed-rate mortgages.
- It’s typically easier to qualify with lower credit score minimums.
- Multiple term length options, such as 5/1 and 7/1 mortgages, give you more flexibility.
Cons of adjustable-rate mortgages
- Variable interest rates are less predictable, making it harder to plan for monthly payments.
- This type of mortgage can become more expensive than a fixed-rate mortgage after a set number of years.
- ARM mortgages can be more complicated and time-consuming to secure.
Fixed-rate vs. ARM mortgages: Which one is right for me?
A fixed-rate mortgage provides stability with predictable monthly payments, but will typically come with a higher interest rate. An ARM mortgage will start out at a lower interest rate and will then fluctuate every year.
How do you know which one works for you? A key factor is time. How long will you be in this house? If you’re likely to move within a few years or you’re flipping an investment property, an adjustable-rate may make sense for you. You’ll likely be selling before the initial interest rate period ends.
If you’re looking for a family home to hold on to for a while, a fixed rate would offer the long-term stability you need. Depending on economic shifts, you may even find a fixed-rate mortgage with a lower interest rate than some adjustable-rate mortgages. Even with a higher initial monthly payment, fixed-rate mortgages are considered a safe bet due to their set rates.
The final word
The path to homeownership can be intimidating, but determining what you want from your mortgage is a great place to start. Understanding the difference between a fixed-rate and adjustable-rate mortgage can help you clearly define what to look for as you begin planning.