Adjustable vs Fixed Rate Mortgages – Which is right for you?

You’re shopping for a house.  You’ve done your homework researching rates, terms, different lenders, etc.  But, did you look at different loan options as well?  How do you decide if a fixed rate or adjustable rate mortgage is right for you?   There are pros and cons to both fixed rate mortgages and adjustable rate mortgages (ARMs).  The loan that makes the most sense for you will depend on your preferences, financial standing, and future plans.

First let’s look at the difference between fixed and adjustable rate mortgages.  Fixed rate mortgages have an interest rate, and therefore a monthly principal and interest (P&I) payment, that remains the same over the life of the loan.  An adjustable rate mortgage, as the name suggests, means that the interest rate can fluctuate over the life of the loan, according to the variables laid out in your original loan agreement.  (For details on understanding adjustable rate mortgages, refer to this post). With both loan types, you can generally choose a term that fits your needs – 10, 15, 20, 30 years.  Assuming that you’d be shopping for a loan term of 30 years, here are some factors to consider.

1.       How long do you plan to stay in your home (or mortgage loan)?  

Many people do not plan to stay in their homes or mortgages long enough to make a fixed rate loan worthwhile.  On average, homeowners move every 8-10 years and refinance their mortgage even more often than that.  If this sounds like you, you may want to consider an adjustable rate mortgage over a fixed rate mortgage.  Rates on fixed rate mortgages tend to be somewhat higher than the initial rate on adjustable rate mortgages.  This is because when the loan is written the lender assumes that you will take the full 30 year term to pay the loan back.  If rates go up over the lifetime of the loan, the lender may end up losing money.  If you do not plan to stay in your home long enough to see the interest rate change on your adjustable rate mortgage, if you expect to refinance your loan in 5 to 10 years, or if you can afford a slight increase in your P&I payment for a year or two before you move, why pay extra interest up front for the reassurance of a fixed rate loan you’re not going to keep long enough to enjoy? 

2.       What are the trends with interest rates? 

If you expect rates to increase over the term of your loan, then it may make sense to lock in a low fixed rate today.  However, if you if you opt for the fixed rate and interest rates later fall, you will have to refinance in order to lower the rate on your mortgage, paying closing costs all over again.  An adjustable rate mortgage, on the other hand, allows your interest rate to adjust to the market, so if rates stay low or drop, the same could happen to the rate on your mortgage without the hassle of refinancing.  Many people worry that if they opt for an adjustable rate mortgage and rates increase, they will start out paying 3% and end up paying 20%.  In reality, if you choose a good adjustable rate mortgage, you do have some protection.  Your ARM will come with rate caps, both for each adjustment and for the lifetime of the loan, to prevent sudden, astronomical rate hikes.   This ties into the first point as well, since the longer you plan to stay in your home, the more uncertainty there is in predicting interest rates. 

3.       How do you budget?  

If your monthly housing budget is very tight and you would not be able to afford even a small increase to your monthly principal and interest payment, the fixed rate loan probably makes more sense even if it will cost you a bit more or you do not plan to stay in the home for a full 30 years.  However, you should consider that a fully escrowed payment on a fixed rate loan could still change.  The P&I payment will remain the same, but varying tax and insurance costs over the time you own your home can still lead to changes in your total monthly payment.  Conversely, if you can budget for changes in your principal and interest payment then the up-front savings of an ARM may make up for payment increases down the road, especially if you use the initial savings to pay down the loan faster.  Each adjustment to the payment is calculated based on the remaining principal loan balance at that time, rather than the initial amount borrowed.  So if you pay your loan down ahead of schedule, you could end up enjoying decreasing monthly payments even if your interest rate increases slightly!

4.       How much flexibility do you want or expect? 

Most fixed rate loans are sold to the secondary market, meaning that while you might get your loan at XYZ Credit Union or ABC Bank, it will probably ultimately end up being owned and serviced by Fannie Mae or Freddie Mac.  This results in essentially a “standard” fixed rate loan that varies very little from one financial institution to another; whereas institutions often retain adjustable rate mortgages on their own books.  This allows for greater flexibility and customization of adjustable rate mortgages.  Even something as simple as splitting your mortgage payment into two bi-weekly payments in order to reduce the amount of interest you pay can be difficult (or cost money) when your loan is sold to the secondary market.

The loan type that is right for you is going to be totally subjective and will depend a lot on how you expect the future to play out.  The most important thing you can do in shopping for a mortgage loan is get the facts straight.  Make sure that you understand all the terms you’re being quoted, and what they actually mean in regard to how your loan will behave. 

As final food for thought, here is a scenario that was put together by Freddie Mac to compare the costs of fixed rate loans versus adjustable rate loans:

In January 2003 the average fixed rate mortgage came in at 5.92%.  For a loan of $200,000 the principal and interest payments for 10 years would have cost you $142,660.  However, an ARM that adjusted annually had an initial rate of 3.99%.  Even after recalculating the interest rate each year, the total amount paid in principal and interest for that same loan and time period came to only $119,181 – a savings of over $23,000!  The adjustments on the ARM loan did increase the rate to 5.47% at its peak, but that is still lower than the 5.92% you would have paid on the fixed rate loan.  And, at one point the ARM rate fell to 2.76%.