While there are many types of mortgages, the biggest division is fixed rate versus adjustable. Although fixed rate mortgages are the most common in the United States, adjustable rate mortgages are the norm in many European countries and Australia.
But just because one or the other is the norm doesn’t mean that it’s best for your homebuying needs. Before you apply for a mortgage, check out the pros and cons of fixed and adjustable rate options, so you can choose your best fit.
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Pros and Cons of Fixed Rate Mortgages
Fixed rate mortgages are mortgages that have a fixed interest rate. They’re the most basic mortgage and the most common. You can get a fixed rate mortgage with almost any term length, but the most common are 30, 20 and 15 years.
The rate you’ll lock in for this type of mortgage depends on the overall market at the time. As of this writing, interest rates are low compared with historical rates, although they’re on the rise.
According to major home lender Freddie Mac, average interest in 1984 was 13.88 percent, compared with 7.44 percent in 1999, and 3.66 percent in 2012. Clearly, locking in a low interest rate is a good idea. Still, this type of mortgage, like any other, has pros and cons.
Fixed Rate Mortgage Pros
- You get a fixed monthly payment. One of the main advantages of a fixed rate mortgage is that your monthly payment will never change. It’s predictable from month to month and year to year, making budgeting much simpler.
- You don’t need to worry about ballooning interest rates. If interest rates rise, your interest rate will still stay the same. This also means you don’t have to worry about increasing payments as interest rates rise.
- You can probably pay it off early. As long as you don’t have any prepayment penalties, you can pay off your mortgage early. In fact, making one extra payment a year can cut nearly five years off of a 30 year, fixed rate mortgage.
- You can find a good fit with flexible options. Standard fixed rate mortgage terms are 15, 20 and 30 years, with shorter terms becoming more and more common for today’s borrowers. Shorter terms often come with lower interest rates, and you can ask for a nonstandard term that might better meet your goals, according to The Street.
Fixed Rate Mortgage Cons
- Your rate stays the same even if interest rates fall. If interest rates are rising, fixed rate mortgages are great. But if interest rates are falling, you’ll be paying more than new borrowers or those with an adjustable rate mortgage.
- Your interest rate will likely start out higher than similar adjustable rate mortgages. Many adjustable rate mortgages start with a lower rate than fixed rate mortgages do. This means adjustable rate borrowers may be able to take out a larger loan than fixed rate borrowers.
- You’ll have to refinance to take advantage of lower rates. While you can take advantage of lower rates, you have to refinance to do it. Though refinancing is often worth your while, it still takes time and usually costs money.
Pros and Cons of Adjustable Rate Mortgages
As you can probably surmise, adjustable rate mortgages have adjustable interest rates. When and how their rates adjust depends on the loan. Some loans adjust their interest rate every year, and others adjust every six months.
The bottom line is that when your mortgage rate adjusts, so does your mortgage payment. When interest rates are falling, this is a good thing because lower rates mean lower payments. When interest rates are rising, on the other hand, larger payments can bust your budget.
There are several types of adjustable rate mortgages, so you should learn about your options before signing up. Some can be easily converted to fixed rate mortgages when you want, and others start out with a fixed interest rate before moving to an adjustable interest rate.
Pros of ARMs
- You may be better able to borrow because of lower initial rates. ARMs often come with a lower interest rate than comparable fixed rate mortgages, which can make a big difference in initial payments.
For instance, as of this writing, Charles Schwab lists its average initial rate for a 5/1 ARM as 2.625 percent. The average rate for a 30-year fixed mortgage is 4.25 percent. On a $100,000 loan, that’s $402 per month for the 5/1 ARM and $491.94 per month on the 30-year fixed. That extra $90 takes away a lot of borrowing power for a homebuyer.
- Your payments will fall when market rates do. When interest rates are falling, ARMs are great because your mortgage payment will fall as well, even though you’re paying down principal at the same rate. And this happens automatically, with no refinancing on your part.
Cons of ARMs
- Your payments will rise when interest rates do. On the flip side, if interest rates are rising, so will your interest rate and your payments. With most ARMs, you’re expected to pay off the principal in a certain amount of time, usually about 30 years. So if interest rates go up, you’ll have to fork over more money every month.
- Your payments may change rather unexpectedly. With many ARMs, rates change every 12 months. If you pay attention to interest rates, you should have some idea of which direction your payments will move. But even then, a sudden spike in interest rates could cause your payment to suddenly increase. Or if you settle into a fixed rate payment for the first few years while interest rates are going up, your budget could be seriously strained by a significant payment increase at the end of the fixed rate term.
- You may eventually need to pay to lock in or refinance to a fixed rate mortgage. Recently, homeowners with ARMs have been doing well, since interest rates have fallen dramatically in the past few years. But now that rates are climbing back up, these homeowners may want to lock in their rate on a convertible ARM, usually for a fee, or refinance to a fixed rate mortgage, which will also cost money.
Which One Wins?
There’s no absolute right answer in the fixed versus adjustable rate mortgage debate. Unless you can foresee interest rates, you can’t know for sure whether a fixed or adjustable rate mortgage will serve you better.
There is, of course, a reason that fixed rate mortgages have tended to be more popular: the predictable payments. Budgeting for mortgage payments is easier when you know what you owe every month.
Plus, with a fixed rate mortgage, you can always kick extra funds into principal payments to pay down your mortgage more quickly. With an adjustable rate mortgage, you may have no choice but to scrape together extra money for higher payments if your interest rate goes up.
With that said, taking a bet on an adjustable rate mortgage could pay off, so long as you know you could handle higher payments in the future.
As a potential homebuyer, it’s your job to carefully consider these two common mortgage options and to decide which option will work best in your situation.