What are Fixed-Rate Mortgages and Adjustable Rate Mortgages (ARMs)?
A fixed-rate mortgage locks in an interest rate that you select at the time you arrange the loan. That rate remains the same throughout the life of the loan, regardless of what happens to interest rates or inflation. With a fixed-rate mortgage, the amount of principal and interest paid varies from payment to payment; however, the total payment remains the same.
Fixed-rate mortgages are usually preferred over adjustable-rate mortgages (ARMs) since they are more straightforward, easier to understand, and more secure for the buyer. However, since the risk to the lender is higher, fixed-rate mortgages generally have higher interest rates than ARMs.
With adjustable-rate mortgages (ARMs), the interest rate can change over time, since it is based on an economic index and continually “adjusts” to changing rates. Usually, the initial interest rate on an ARM is set below the market rate on a comparable fixed-rate loan, which then gradually rises with time. Your initial monthly principal and interest payments will also be lower than on a fixed loan.
ARMs, generally, have a fixed period (from one month to 10 years) during which the initial interest rate remains constant. After this time, the interest rate adjusts at a pre-arranged frequency. Shorter adjustment periods generally carry lower initial interest rates.
Advantages and Disadvantages
A fixed-rate mortgage protects the borrower from sudden and potentially considerable increases in monthly mortgage payments on the occasion the interest rates rise. Moreover, fixed-rate mortgages are easy to understand, comprehend, and vary little from lender to lender.
However, the major disadvantage of fixed-rate mortgages is qualifying criteria. In other words, when interest rates are high, qualifying for a loan is more difficult because the payments are less affordable.
Adjustable rate mortgages (ARMs) are considered attractive because they may offer low initial payments and enable qualified borrowers to obtain a larger loan.
The main disadvantage of an ARM is the fluctuation in interest rate. In other words, adjustable rate mortgages can often be problematic as the monthly payments may change frequently over the life of the loan. The disadvantage increases when the interest rate rises. It is very common for an ARM to start at a fixed rate and then convert to an adjustable rate after a few years.
You might be a good candidate for an adjustable-rate loan if you’ll be able to afford higher mortgage payments should rates go up, if you are confident that rates will remain stable or decline in the future, or if you plan on staying in your home less than seven years.