While there are many different types of mortgages, they all fit under two general categories — fixed rate mortgages and ARMs, or adjustable rate mortgages. The rate, or course, refers to the interest rate.
In a fixed rate mortgage, the interest rate remains the same throughout the life of the loan. When you take out a 30 year mortgage with a 5 percent interest rate, you can count on the interest rate remaining the same for the entire 30 years.
However, in an adjustable rate mortgage, the rate on your mortgage changes based on some named index. The loan agreement will state how often the adjustable rate can change, as well as how much it can change at once, annually and over the life of the loan. Depending on the mortgage, there may be no limitations on the amount of adjustment.
Choosing between fixed rate mortgages and adjustable rates can be a difficult decision for many homeowners. There are advantages and disadvantages to each type of mortgage. Your individual financial circumstances and your personal preferences will determine which type of mortgage is best for you.
Advantages of Fixed Rate Mortgages
The most obvious advantage of a fixed rate mortgage is stability and predictability. When you choose a fixed rate mortgage, you’ll know in advance exactly how much your mortgage will cost over the entire life of the loan. That also means that you’ll know exactly how much your payment will be each month, which makes it far easier to budget and plan your money in advance.
Advantages of Adjustable Rate Mortgages
The interest rate of an adjustable rate mortgage is pegged to a variable index of some sort. If that index rises, the interest rate on your mortgage goes up. If it drops, so does the interest rate on your mortgage. Because of the inherent risk to the borrower, interest rates on ARMs tend to start out lower than the interest rates on a fixed rate mortgage. And while interest rates do tend to vary over the course of time, they may go down as easily as they go up. That means that if you choose an adjustable rate mortgage, there is a chance that you will be paying less in interest at various times during the life of your mortgage.
ARMs vs. Fixed Rate Mortgages
With fixed rate mortgages, you trade a lower interest rate and the chance to save money if the interest rates drop for the convenience and certainty of having a monthly mortgage payment that is always the same. If you choose an ARM, you don’t know how much you’ll be paying for the loan in full until it is paid off. You also can’t count on your monthly mortgage payment remaining the same for more than the length of one adjustment period.
Why Choose a Fixed Rate Mortgage?
A fixed rate mortgage is the best choice for you if:
- You are willing to pay a slightly higher interest rate in return for certainty
- You are averse to taking the risk that your mortgage payment will increase faster than you can adjust to the difference
- You want to know exactly what your mortgage will cost over entire life of the loan
- You don’t mind taking the chance that you’ll sometimes pay higher interest than the prevailing interest rate
- You like being able to budget your mortgage payment
- You are on an inflexible income
- You believe that income rates will rise over time
Why Choose an Adjustable Rate Mortgage?
An adjustable rate mortgage is the best choice for you if:
- You want to start with a lower interest rate than the prevailing rate
- You don’t mind the risk that your interest rate — and thus your monthly mortgage payment — is likely to increase over time
- Your monthly income is flexible, or is substantially more than your initial monthly payment amount
- You are not risk averse
- You believe that interest rates will fall over time
Another reason for taking an adjustable rate mortgage is to give yourself a chance to improve your credit rating. If your credit rating is marginal, you’re unlikely to qualify for a low interest rate mortgage. Your best option may be to take out an adjustable rate mortgage for two to five years before attempting to refinance into a fixed rate mortgage. Two to five years of on-time payments on your mortgage will improve your credit score and may qualify you for a lower interest rate fixed rate mortgage.
Before deciding if an ARM or fixed rate mortgage is best for you, take the time to carefully evaluate your personal financial situation. If you value the predictability and stability of consistent monthly payments, a fixed rate mortgage may be your best choice. But if you’re willing to ride the wave of fluctuating interest rates, consider an ARM.