Know the difference: Fixed vs. adjustable-rate mortgages

Quick insights

• A fixed-rate mortgage is a home loan whose interest rate and payment amount generally stay consistent throughout repayment.
• An adjustable-rate mortgage has an interest rate that adjusts depending on multiple factors, including broader market rates, so it may rise after an initial period.
• A fixed-rate mortgage provides predictability throughout repayment, while the adjustable-rate mortgage can have a lower initial rate, which can make buying more affordable.

Are you preparing to buy a home soon? Knowing the difference between a fixed-rate mortgage and adjustable-rate mortgage (ARM) can help you choose the right loan for your financial situation, long-term goals and preferences. In this article, we’ll compare fixed-rate vs. adjustable rate-mortgages and explain how the differences between them can impact a borrower’s bottom line.

What is a fixed-rate mortgage?

A fixed-rate mortgage offers a stable, predictable loan option for homebuyers. With a fixed-rate mortgage, the interest rate stays the same throughout the course of the loan, regardless of the broader economic environment. The principal and interest portion of the monthly payment is generally the same size, and this consistency can make it easier for borrowers to plan financially around their fixed-rate mortgages.

How fixed rates are determined

When setting up a fixed-rate loan, the rate offered to a borrower are calculated based on several factors. Those typically include the borrower’s current credit score, market rates (more on this later), down payment size and the desired loan term. The rate associated with the loan becomes a sort of “snapshot in time,” unaffected by fluctuations in the market. The rate can only be adjusted by refinancing.

Fixed-rate mortgages and affordability

The rates offered for fixed-rate loans tend to be higher than those seen with adjustable-rate mortgages. This can make fixed-rate mortgages more expensive—overall and monthly. Despite the higher rates, fixed-rate loans may be preferable for their stability over adjustable-rate mortgages.

Pros and cons: Fixed-rate mortgages

Let’s review the potential advantages and disadvantages of fixed-rate mortgages.

Advantages of a fixed-rate mortgage

• Predictable: The principal and interest portion of each mortgage payment is generally the same size. This helps make financial planning and budgeting more straightforward for the buyer, month after month, year after year.
• Stable: The broader economic environment has no impact on the loan terms, which protects the borrower in times of inflation and market instability.

Disadvantages of a fixed-rate mortgage

• Potentially higher rates: Fixed-rate mortgages may start with higher rates compared to initial rates of adjustable-rate mortgages, depending on the interest rate environment.
• Less flexible: When market rates go down, the borrower would need to refinance their loan to take advantage. This often involves a separate approval process and closing costs.

What is an adjustable-rate mortgage?

An adjustable-rate mortgage is a type of home loan whose rate changes over time. Most ARMs start at a lower initial rate before switching to a structure where the rate is adjusted periodically (typically every six months). Rate adjustments are generally linked to a specific benchmark or index, such as the Secured Overnight Financing Rate, with an additional built-in margin.

How adjustable rates are determined

Similar to a fixed-rate loan application, the lender will consider a potential borrower’s credit history, down payment size and desired term. To set an adjustable rate, the current market environment is important both at the outset (for the initial rate period) and throughout the loan term. Here are some important factors:

• Index fluctuations: ARMs are tied to a specific financial index, such as the Secured Overnight Financing Rate. As the index rises or falls, so does the interest rate on the mortgage.
• Economic factors: Broader economic conditions such as inflation, economic growth and central bank policies (for example, Federal Reserve decisions) can influence the indexes to which ARMs are associated.
• Caps and floors: Most ARMs have rate caps that limit how much the interest rate can increase or decrease during each adjustment period and over the life of the loan.

Managing changing rates

Interest rate changes can be positive or negative for the borrower. When rates turn in the borrower’s favor, payments are smaller, and (if sustained) lower rates could mean owing less overall. However, when rates rise, the borrower may need to adjust their budget to account for a higher monthly payment. Interest fluctuations can make it more important to save, watch the market and remain flexible.

Adjustable-rate mortgages and affordability

The initial rate offered with an adjustable-rate mortgage tends to be lower than that of fixed-rate loans. This may keep payments low for a while and enable a buyer to purchase a more valuable home. The rate structure can also be an advantage for someone who is planning to move or refinance in a few years, or a buyer who is anticipating earning more income over time.

Pros and cons: Adjustable-rate mortgages

Let’s review the potential advantages and disadvantages of fixed-rate mortgages.

Advantages of an adjustable-rate mortgage

• Lower initial payments: ARMs often offer lower initial rates, making them attractive for short-term savings and for borrowers planning to sell or refinance before rates adjust.
• Potential for decreasing rates: If interest rates fall due to market conditions, borrowers can benefit without refinancing their mortgages.

Disadvantages of an adjustable-rate mortgage

• Risk of rate increases: Monthly payments may increase significantly over time if interest rates rise, which could strain an unprepared budget.
• Complexity: The variability, terms and conditions of ARMs can be complex to understand and require more engagement or monitoring than fixed-rate mortgages.

How to decide between a fixed vs. adjustable-rate mortgage

A fixed-rate mortgage is more standard than an adjustable-rate mortgage and generally a good fit for most qualified borrowers. A person weighing all their options, including an adjustable-rate mortgage, may want to consider:

• Personal financial stability: Maintaining a steady income and personal savings could be especially important for ARM borrowers, whose payment size may vary over time.
• Risk tolerance: Financial stability and overall comfortability with change can help make a borrower a better candidate for an ARM.
• Current and projected interest rate trends: What’s the current market looking like? What are experts predicting? If rates are low compared to previous years, a fixed-rate mortgage can lock in an uncommonly good rate.
• Long-term personal goals: If you’re planning to move, feeling confident about your income trajectory or are open to refinancing, an ARM may be advantageous.

As with any major financial decision, professional guidance can help you assess your circumstances and settle on a fixed- or adjustable-rate mortgage.

In summary

For certain buyers, there will be compelling advantages to both types of mortgages, fixed- or adjustable-rate. In general, most people tend to prefer the stability of a fixed-rate mortgage. But for those who are fine with rate changes during repayment, an adjustable-rate mortgage can be a strategic choice. A trained professional can review your options with you and help you make an informed decision.