After deciding on a home to purchase, one of the biggest decisions you’ll face is whether to go with a fixed-rate or adjustable rate mortgage. The decision you make can impact not only your monthly payment but whether you’ll need to refinance or move again at a later date.
Fixed-rate mortgages are the most common type of mortgage loans. Although the interest rate doesn’t change during the term of the loan, the payment can vary slightly. That’s because a fixed-rate mortgage consists of four parts: principal, interest, property taxes and homeowner’s insurance. While your principal and interest rate won’t change, your property taxes and homeowner’s insurance most likely will over time.
Most fixed-rate loans are offered at 10-year, 15-year, 20-year, and 30-year terms, but they can be any length. The obvious benefit to these loans is that regardless of economic changes, such as interest rate hikes or inflation, your loan payment will remain roughly the same. That predictability allows you to plan more accurately long term.
An adjustable-rate loan—or ARM, for short—is a mortgage loan with an interest rate that is linked to an economic index. Following an initial period where the interest rate is fixed, it resets periodically based on its economic index.
These loans are often described in numerical terms such as 1/1, 3/1, or 5/1. The first number represents the length of the initial period while the second number represents how often the rate can adjust after the initial period. So, for example, a 3/1 ARM would have a fixed interest rate for three years and adjust annually in the following years.
ARMs can be attractive because the payments are low during the initial period, allowing you to purchase more house. However, they can be extremely risky if the interest rate goes up or if your income doesn’t increase as expected.
Which is right for you?
That depends largely on your personal situation. ARMs may make sense for borrowers who do not plan to live in their home for more than a few years and for those who expect an increase in income (or more disposable cash) before the adjustments begin.
ARMS can also benefit buyers who can afford to purchase multi-million-dollar properties. The difference between an ARM monthly payment (during the initial period) and a fixed-rate monthly payment could be substantial. If invested, that difference can turn a significant amount.
ARMs are a gamble. If the interest rate goes up, which it is likely to do at some point in the near future, then your payments will go up, too, after the initial period. Your only recourse would be to refinance or move.
Fixed-rate loans offer the security of knowing what your monthly payment will be (approximately) 10 years from now, but they also don’t allow you take advantage of new lower rates, if the interest rate drops. That, however, is something that is unlikely to happen right now given how low rates are already.