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Fixed-rate versus adjustable rate mortgages

Fixed-Rate Versus Adjustable-Rate Mortgages: What You Should Know 
If you like choices, entering the housing market offers plenty of them. Even though inventory isn't quite as high as in previous years, nearly 2 million existing-homes up for sale is quite a few, according to the National Association of Realtors. Architectural home styles (e.g. Victorian, American colonial, ranch, contemporary, etc.) run the gamut as do mortgage types, including FHA loans, VA loans, conventional loans and more.

As it pertains to interest rates, though, it comes down to two: fixed versus adjustable. Each has its pluses, minuses and distinctions that make it different from the other. But don't let the binary nature of these fool you; there are a variety of considerations within each that you need to be mindful of to figure out which one is the better of the two for you.

If you're in the market to buy a house and hoping to take out a loan, here is a bit more on each that can help you decide the appropriate rate for your needs.

What is a fixed-rate mortgage?
As its title implies, a fixed-rate loan (FRM) includes interest rates that remain the same. This means that no matter how long you take out a mortgage for, the rate does not change from what it was when you initially applied for the mortgage. Due to market fluctuations, interest rates are subject to change on a fairly regular basis.

What makes FRMs worthwhile?
For many years, FRMs have been the most popular form of interest among mortgage borrowers. Part of the reason for this is they are inherently predictable. Generally speaking, people are creatures of habit. They appreciate the comfort in knowing what they can expect. This is particularly true as it pertains to finances. With an FRM, they can rest comfortable knowing that regardless of the rate environment, they'll pay the same interest rate for the life of their loan.

Currently, FRMs are quite low, especially when you compare them to where they once were in the 1970s and 1980s. In the late 1970s, rates were over 10% and even higher than that throughout much of the 1980s. Today, they average around 3.49% during the first week of September 2019, according to Freddie Mac. Last year during the corresponding period, they were 4.5%.

Of course, the amount of interest borrowers pay is determined on a case-by-case basis after your lender takes a look at your finances and credit history. 

What are the potential downsides of an FRM?
The main takeaway advantage of FRMs is they remain locked in. At the same time, though, the attractive element of FRMs can also be a detriment should rates lower. In other words, because they stay the same regardless of market forces, you could wind up spending more in interest compared to someone who takes out a loan later on if interest levels slip. 

What is an adjustable-rate mortgage?
On the opposite end of the interest type spectrum are loans with adjustable rates. This means that what you wind up spending in interest for however long you take out the mortgage for, will vary, perhaps even considerably. 

Much like FRMs, adjustable-rate mortgages (ARMs) are low historically speaking. As the most recent available data from Freddie Mac shows, a 5-year Treasury-indexed hybrid ARM averaged 3.30% for the week concluding Sept. 5. That's down from 3.93% 12 months earlier. 

Again, what you spend in interest may be different depending on your situation and when you decide to enter the housing market. It may also be influenced by the loan type you select.

What makes ARMs worthwhile?
The upside of ARMs is that, generally speaking, they usually start out with a lower interest rate, according to the Consumer Financial Protection Bureau. This can make them highly appealing to first-time homebuyers, who may not have as much money as they would like fresh out of college or starting a family. According to NAR data, first-time buyers represent approximately 33% of those who are looking to buy.

The low interest rate may remain the same for several months or perhaps even years. However, once the introductory period concludes, ARM borrowers frequently wind up spending more than they did originally, CFPB noted.

Take what is known as a 5/1 ARM as a classic example, yet another loan option of many that are offered by lenders these days. These products combine FRMs and ARMs by the rate staying locked in for the first five years. Thereafter, however, the rate is subject to change with each passing year until the loan is ultimately paid off completely. 

What are the potential downsides of an ARM?
Herein lies the rub with ARMs: They're inherently unpredictable. The amount you spend in interest in one year can be notably more than you pay 12 months later. This can present financial complications depending on your work situation and how you budget your money. At the same time, though, the difference in interest may not be all that significant at all, making the ARM potentially more worthwhile from a cost savings perspective than an FRM. 

When should you choose an FRM? An ARM?
While choices are nice to have, they, at the same time can be difficult to make. Selecting between an FRM and ARM is no exception. However, there are certain scenarios in which one may be more preferable than the other. Say you're in a comfortable situation with regard to work or home life and you don't expect any major changes in the foreseeable future. There's a certain comfort in this and can make choosing an FRM a smart move, especially if the locked-in rate is something that works for your budget. In short, if it ain't broke, don't fix it. 

As for when a variable rate may be more appropriate, consider how long you intend to stay in the home you plan on buying. Is this a house you see yourself living in long-term or is it more of a starter home? Perhaps you or your spouse are in the military, which would entail having to move to another state. In either of these situations, an ARM may be more appropriate because the way in which rates adjust can enable you to pay a lower interest rate early on.

If an adjustable-rate mortgage seems like the best choice, you may want to ask a few questions of your lender to get an idea of how the ARM changes over time. Here are a few of them, as suggested by the CFPB.

How soon will the rate change?
As we previously mentioned, exactly when an ARM adjusts varies from lender to lender. Much of this is dependent on the type of ARM you have. For example, a 5/1 ARM will stay the same for a longer period than will a 3/1 ARM, specifically for five years versus three. Both of these loan products are hybrid ARMs and may come in other durations (e.g. 7/1, 10/1, 15/15, etc.).

How high will rates go when they do adjust?
This is a particularly important question to ask, because what you spend for the first several years could be notably different than those following. Your mortgage provider will be able to tell you how high they'll go under the terms of the loan contract. There will be a cap, which will prevent the monthly mortgage payment from stretching your budget beyond its limit. 

Is refinancing a possibility?
Something that many people do to get a lower interest rate is taking advantage of refinancing. If you get to a point in which an ARM no longer makes sense. You may be able to switch to a fixed-rate loan. However, as CFPB cautions, don't select an ARM with the assumption that you'll be able to refinance. Even though it may be possible for you to do, market forces - as well as your own financial situation - is subject to change, which would make refinancing a move that's not in your best interest.

At Residential Mortgage Services (RMS), we know you have lots of questions about the homebuying process. We're here to offer answers in a clear, concise manner. Whether you're seriously thinking about entering the market or just want some basic information, don't hesitate to ask. We’ll guide you home.