When you apply for a home loan, you’ll be given the option of either a fixed or a variable rate mortgage loan. Both of these loan options have some upsides and some potential negatives, but ultimately, the one that works best for you will depend on a number of different factors.
Fixed-rate mortgages offer borrowers the stability of the same interest rate and monthly payment over the life of the loan. That’s a huge plus for home buyers who want predictability in their payments. Variable-rate mortgages, on the other hand, have interest rates that fluctuate from time to time. These loans come with more uncertainty, as rates could increase in the future — but they also come with perks like lower starting interest rates.
When deciding the right type of mortgage rate for you, it’s important to consider how long you plan to stay in the home, your risk tolerance and whether you have wiggle room in your budget for an increased mortgage payment down the road. There’s more to that formula, though. Here’s what you should know about these types of mortgage loans.
What are fixed mortgage rates?
A fixed mortgage rate is a rate that remains the same for the entire life of the loan. Fixed-rate mortgages are the most common type of home loan. When borrowers apply for this type of loan, the interest rate they’re given will be determined by factors such as their income, credit scores and the current market rates.
The rate on a fixed mortgage loan never changes over the life of the loan. That means that fixed-rate mortgages come with consistent monthly payments since there are no rate fluctuations. The amount you pay per month in the first year of the mortgage is the same as the monthly payment you pay in the 25th year.
The only difference is how much of the monthly payment goes toward interest vs. principal. As you pay down your principal, your loan accrues less interest, which means less of your payment goes toward the interest portion of your loan. As a result, more of your monthly payment goes toward principal each year of your loan.
The 30-year fixed-rate mortgage is the most popular type of home loan. This type of fixed-rate loan gives buyers a 30-year period to pay off their loans. Fixed-rate mortgages can also come with 10-year, 15-year and, less commonly, 20-year terms.
[ Read: What Are the Different Types of Mortgages? ]
What are variable mortgage rates?
A variable mortgage rate is a rate that changes periodically throughout the life of the loan. An adjustable-rate mortgage (ARM) loan starts with a period of fixed interest that could last anywhere from one to 10 years. During this period, the mortgage rate is guaranteed not to change.
Adjustable-rate mortgages appear as two numbers. For example, you might have a 5/1 mortgage. This indicates that your loan has a fixed-rate period of five years and that your rate can change no more than one time per year after that.
Once the fixed-rate period passes, which is five years in this case, the mortgage rate can change periodically (often every year) based on a specific benchmark, such as LIBOR or the rate on a Treasury bill. As the market rate increases, variable-rate mortgage borrowers will see their mortgage rates increase, and vice versa. There’s always a chance your rate will go down if rates drop.
As the variable rate on a loan increases or decreases, so does the monthly payment. The good news is that these loans come with rate and payment caps. Your interest rate and monthly payment are guaranteed not to exceed a certain amount as determined at the time you take out the mortgage.
[ Read: Refinance Your Fixed-Rate to ARM Mortgage ]
Comparing the two types of mortgage rates
Fixed and variable rates are the two rate options you’ll have to choose from when you buy a home. Both are very different and come with their own set of perks.
Advantages of a fixed rate
Fixed mortgage rates provide predictability to the borrower. Because the interest rate and the monthly payment amount never change, homeowners know exactly how much they’ll pay each month over the life of the loan. You won’t have to worry about your monthly payment increasing substantially and becoming unaffordable.
Fixed-rate mortgages also allow borrowers to lock in low rates during the loan process. Imagine that you bought a house during a year like 2020, when interest rates were historically low. A fixed-rate mortgage ensures that you get to keep the low rate for the entire loan term, no matter what happens to the market rate.
Advantages of a variable rate
While variable rates don’t come with the stability that a fixed mortgage rate does, they still have their own set of advantages. First, adjustable-rate mortgages tend to have lower starting interest rates. These loans come with a fixed-rate period at the start of the loan, which is when you’re likely to see the low rate. The interest rates available for this period are often lower than the rate you’d be able to get on a fixed-rate mortgage under the same market conditions.
Variable-rate mortgages also allow borrowers to take advantage of low market rates later in the life of their loan. If you lock in a fixed interest rate when rates are high, you can’t take advantage of rate decreases unless you refinance your loan. With a variable rate, you’ll see your mortgage rate drop if the market rate goes down.
[ Read: How to Get the Best Mortgage Rates ]
Should you get an ARM or a fixed-rate mortgage?
Choosing between a fixed-rate and adjustable-rate mortgage can be challenging. Borrowers often want the stability that comes with fixed mortgage rates, but also want the lower rate available to ARM borrowers. Unfortunately, you can’t have both.
One of the first things to consider is how long you plan to stay in the home. If you’re planning to buy a home to stay in for a few years, an ARM might give you the best of both worlds. You’ll lock in the lower starting rate that comes with an ARM, but you can sell the home and pay off the mortgage before your fixed-rate period ends.
An ARM may also be a good option if you have lots of wiggle room in your budget. With this type of loan, you run the risk of your interest rate increasing later on, and, in turn, your monthly payment also increases. If you have plenty of room in the budget for a larger mortgage payment and are willing to roll the dice on the interest rate fluctuations, then you might decide an ARM is right for you.
ARMs can also be a good option for certain real estate investors. If you plan to buy an investment property to flip in the next couple of years, an ARM might help you to save money.
Ultimately, a fixed-rate mortgage is the option that most people choose. This type of loan gives borrowers the flexibility to stay in their homes as long as they want without the fear of a rate or payment increase that would make their home unaffordable. Even though these loans start with slightly higher interest rates, you could still pay lower interest over the entire life of the loan. Unlike an ARM, there’s no chance of your interest rate increasing in the future.
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Too long, didn’t read?
Fixed and variable mortgage rates are the two options that are available when it comes to buying a home. Each type of rate comes with its own advantages. Fixed-rate mortgages offer the predictability that many borrowers desire, while ARMs offer lower starting interest rates and the opportunity to take advantage of rate drops in the future. ARMs come with more risks than the stability of a fixed-rate loan, but either can be a good fit. It will all depend on what you need from a home loan and what your end goals are.
Source: thesimpledollar.com