Fixed Rate Mortgage versus Adjustable Rate Mortgage

Posted September 13 2014
by PenFed Team
Person writing "pros" and "cons" list.

Not all mortgages are created equal. While you may think you’re on the fast track to home ownership, once you’ve found your dream house and decided on a purchase price, you still have to pick the right mortgage.

Buying a home is one of the biggest financial decisions most of us make, and getting the right mortgage for your situation can mean good things for your personal finances.

One of the choices you’ll run into is whether you want a fixed rate mortgage or adjustable rate mortgage (usually abbreviated as “ARM”). Don’t let the jargon scare you off, because these terms are actually fairly straightforward explanations of how the interest on the loan works: A fixed rate loan has a single fixed interest rate based on the market when you get the loan, while an adjustable rate loan has a rate that adjusts over time according to future interest rates.

In short: A fixed rate mortgage gives you long-term predictability, but an adjustable rate mortgage locks in a low rate (usually slightly lower than offered for fixed rates) for a certain period of time and then changes based on future interest rates, which can be ideal if rates are dropping.

Which type of mortgage is best for you? That depends on a lot of factors, but we’ll walk you through the advantages and disadvantages of each type of loan.

Why Would I Want a Fixed Rate Mortgage?

An important feature of a fixed rate mortgage is simplicity. The interest rate you have on day one will be the same interest rate you’ll have for the life of your loan, which makes it easy to understand and budget for.

If you expect interest rates are on the rise, a fixed rate mortgage—even if the initial rate is higher than a comparable adjustable rate mortgage—could be a good move, locking you in for lower payments over the life of your home loan. The predictability of a fixed rate mortgage is great if you plan to stay in your home for a long period of time to take best advantage of it.

However, if interest rates are dropping, signing on for a fixed rate mortgage at today’s rates will lock you in with a higher payment—and while you could always refinance to get a lower rate, refinancing can be time-consuming and sometimes the closing costs could eat up any monthly savings you might get out of the deal.

If you don’t plan to stay in your house for a long time, you can likely get better rates by getting an ARM instead. Because rate adjustments don’t kick in for a certain fixed period of time, if you plan to sell within the next few years, you can lock in a lower rate without having to worry about the adjustment period at all.

Why Would I Want an Adjustable Rate Mortgage?

ARMs are less predictable than their fixed rate cousins, and that keeps some new homebuyers away—but ARMs can be a very financially savvy move if you’re aware of how they work.

You’ll find ARMs are described by two numbers, like 1/1, 3/1, or 5/1. The first number is the number of years before your first adjustment period, while the second is how often the loan adjusts to current interest rates. Knowing that, smart shoppers can already see how this could work to their advantage.

An ARM’s initial interest rate is usually lower than a comparable fixed rate loan, which means lower payments. If you’re aware of the fixed period of your ARM, and do not plan to keep the house any longer than that, this means you get the advantage of the ARM’s lower rates without having to deal with their long-term unpredictability. And since you’re making lower payments, this could mean you have more to put in savings or to retirement—or perhaps, allow you to buy more house.

The disadvantages of ARMs, however, can be great—especially if you get into one without understanding how they work.

While the amount your payment can go up is usually capped, sometimes the first adjustment won’t be capped—which means that that first adjusted payment can be a real jump. If interest rates are on the rise, your payments will keep going up, which can be difficult to budget for in the long term. However, if interest rates are falling, you could find your payments dropping; while a fixed rate mortgage would need to refinance to take advantage of lower rates.

In the end, a fixed rate mortgage versus adjustable rate mortgage comes down to whether you value long-term predictability (and plan to stay in your home for a long period of time), or want to get the lowest possible up-front rate (and perhaps don’t plan to stay in your home for long).

Whatever you’re looking for, be sure to talk to your lender so you fully understand your options. Different lenders will have different mortgage products available, especially in adjustable rates.

Shopping for a mortgage? PenFed has a variety of both fixed and adjustable rate mortgages available.