Know before you sign!
Definitions
The best way to understand the differences is first to understand what each loan is all about. Let’s start by defining both options: A fixed-rate mortgage is a home loan with an unchanging interest rate for the entire loan duration. An adjustable-rate mortgage is also called an ARM. This type of loan has a low introductory rate for a fixed period, then the interest rate will fluctuate during the remainder of the loan term. The homebuyer’s personal situation determines which option works best to purchase or refinance a home.
Fixed-rate mortgage
The interest rate remains constant throughout the loan term, providing predictability and making budgeting easier for homebuyers. The monthly payments are stable with a fixed-rate loan and will not change, providing further financial stability. One of the strongest selling points of a fixed-rate mortgage is that the homeowner is protected from rate increases and the broader economic activity that impacts mortgage interest rates.
Fixed-rate mortgages are relatively straightforward. Borrowers with fixed-rate loans know what to expect and can feel comfortable that their payments will not change unless they refinance or sell their home. Refinancing with a fixed-rate loan is also straightforward. If rates go down and you are eligible to refinance, you can take advantage of the lower rates, but you will still need to pay closing costs and other fees associated with the loan process.
ARMs
Initially, Adjustable-rate mortgages (ARMs) offer a lower interest rate than fixed-rate loans. However, after an initial fixed-rate period (e.g., 3 years, 5 years), the interest rate can fluctuate based on the financial index upon which it is based. Payments can change due to the change in interest rates.
Homebuyers should be prepared for potential fluctuations in rate and payment after the loan’s introductory period ends. This kind of instability can be challenging for some borrowers. Since the rates on ARMs are tied to indices that reflect general market conditions, it is difficult to predict what they will do. In some cases, they could go down, but more often, they go up. Homeowners with ARMs should be confident they can still afford their monthly payments if rates increase.
ARMs are more complicated than fixed-rate loans
ARMs require an understanding of index rates, margins, and adjustment periods. Homebuyers will trend towards ARMs in a high-rate environment, hoping that after the introductory period, they can refinance into a fixed-rate mortgage if fixed rates are lower. A strategy of refinancing after the initial period is over can be risky. It may not work out for many reasons.
For example, if the mortgage rates are not lower than the rate on the ARM, if the ARM has hefty pre-payment penalties, or if the housing market declines during the ARM term, and a borrower does not have the equity needed to refinance. Having a clear strategy and knowing the risks with an ARM is essential. Working with an experienced loan officer who can lay out all your options is crucial.
If rates fall while you are past the loan’s introductory period with an ARM, you may benefit from the lower rates without having to refinance, but you will still face instability in the market. Adjustable-rate mortgages adjust based on a schedule; you will know your schedule when you take out your loan. Some ARMs have monthly adjustments, and some have yearly adjustment periods.
Key points differences between fixed-rate loans and ARMs:
- Rate Stability
- Risk and Flexibility
- Complexity
Remember, while fixed-rate mortgages are safer and more popular, ARMs can be advantageous in specific situations. Homebuyers must consider their financial goals and risk tolerance when choosing between the two options. Working with an experienced lender like Mortgage Equity Partners and consulting with a licensed loan officer will help you understand the difference between fixed-rate and adjustable-rate mortgages and which is right for you.
