At some point in their lives, most people will find themselves in some sort of debt. Mortgages, which are used to pay for homes, represent the largest sources of debt most people will ever take on.
Needless to say, a mortgage on a home will cost you quite a bit over time. Mortgages can be quite expensive after repaying the actual cost of the home with additional interest.
It’s only natural that people would be looking for ways to cut down the costs associated with buying a home. One of the easiest places to save money on a mortgage is on the interest rate, which can mean a difference of thousands of dollars over the life of the loan. There are two types of mortgage rates available: fixed and adjustable rate mortgages (or ARM). It pays to know the difference between the two.
What Is the Difference Between Fixed-Rate Mortgages and ARMs?
A fixed-rate mortgage is a home loan with a locked-in interest rate throughout repayment. This rate is “fixed” after you are approved for a mortgage. Afterwards, it will never change.
The interest rate on your loan is determined by how the market is currently performing at the time you take the loan, and the rate stays the same throughout market fluctuations. The constant interest rate offers more certainty when determining how much interest is owed each month on top of the regular principal.
Comparatively, an adjustable rate mortgage doesn’t stay fixed throughout the repayment term; in fact, it will fluctuate over time with the market rate. There are several ARM options including 3/1, 5/1, 7/1, and 10/1.
Here are a couple examples of how they work. A 3/1 ARM offers a fixed interest rate for the first three years of repayment; afterwards, the rate is adjusted every year. Similarly, your interest rate will be locked in for the first 10 years of a 10/1 ARM and adjusted annually afterwards.
As you can see, there are some differences between fixed-rate mortgages and ARMs. Fixed-rate mortgages keep the same interest rate throughout. Adjustable rate mortgages are hybrid interest rates with an initially fixed rate and variable rate following the initial fixed period.
Basic Considerations Behind Fixed & Adjustable Rate Mortgages
Fixed-Rate Mortgages Offer More Certainty
If you’re looking for an easier way to budget for a home, fixed-rate mortgages might be for you. Because their rate is constant, you always know how much you’ll have to pay in interest. They’re easy to understand, but they come with a potential drawback.
If the market trends low, you could be stuck paying a higher rate compared to the market for the full life of your loan. On the other hand, if the market is high, you could save money because the rate will not rise.
ARMs Are Impacted by Market Trends
ARMs can be tricky. Due to fluctuating rates, repayment expectations are not as clear cut. Predicting future payments can be challenging, but there’s a chance they might decrease if the market stays low.
That being said, the same thing can happen in reverse; you might end up paying more than your introductory rate (and more than you would on a fixed-rate loan) if things go poorly. In order to entice people to take this risk, many ARMs offer lower-than-average rates during the introductory period.
Which Type Should You Choose?
If you are averse to risk and uncertainty, a fixed-rate mortgage is likely the better option. If you can get a 10/1 adjustable rate mortgage and are confident enough to take on some level of risk, you may strike a great deal on your home loan.
The challenge with adjustable rate mortgages is that trying to predict the market is futile; if it could be done, anyone could become a stock millionaire.
Related: 3 Ways to Eliminate Mortgage Debt
The best anyone can do when considering an ARM is to analyze market trends and consider whether they could continue to make home payments if their rate should rise and increase the monthly cost of their mortgage. They may be able to find a great deal that way.
Overall, fixed-rate mortgages are generally considered a wise financial move for their security and simplicity, which becomes more important given the size of mortgage debt. While ARMs are riskier, they can also be rewarding. Ultimately, it comes down to figuring out your own personal preference.
Which type of mortgage do you have on your home and was it the “right” choice?
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.