Difference between Fixed-Rate vs Adjustable-Rate mortgage?

Educational content | by Advisor Voices | July 24, 2016
Difference between Fixed-Rate vs Adjustable-Rate mortgage?

Now that you know how ARMs compare to fixed-rate loans, how do you decide which one makes the most sense for your situation?

What is a Fixed-Rate Mortgages?

A fixed-rate mortgage (FRM), often referred to as a “vanilla wafer” mortgage loan, is a fully amortizing mortgage loan where the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or “float”.

A fixed-rate mortgage charges a set rate of interest that does not change throughout the life of the loan. Although the amount of principal and interest paid each month varies from payment to payment, the total payment remains the same, which makes budgeting easy for homeowners.

The most popular adjustable-rate mortgage is the 5/1 ARM:

  • The 5/1 ARM’s introductory rate lasts for five years. (That’s the “5” in 5/1.)
  • After that, the interest rate can change every year. (That’s the “1” in 5/1.)
  • Some lenders offer 3/1 ARMs, 7/1 ARMs and 10/1 ARMs.

What is a Adjustable-Rate Mortgages?

Adjustable-rate mortgages, or ARMs, have monthly payments that can move up and down as interest rates fluctuate.

Most have an initial fixed-rate period during which the borrower’s rate doesn’t change, followed by a longer period during which the rate changes at preset intervals.

The interest rate for an adjustable-rate mortgage varies over time. The initial interest rate on an ARM is set below the market rate on a comparable fixed-rate loan, and then the rate rises as time goes on. If the ARM is held long enough, the interest rate will surpass the going rate for fixed-rate loans.

Fixed vs adjustable loans

A fixed-rate loan features the same payment over the life of your loan. The property taxes and homeowners insurance will go up over time, but for the most part, payment amounts on these types of loans vary little.

Early in a fixed-rate loan, a large percentage of your payment goes toward interest, and a much smaller percentage toward principal. The amount paid toward your principal amount goes up slowly each month.

Why people choose a Fixed-Rate Mortgages?

Borrowers choose a fixed-rate loan in order to lock in a low rate. People choose fixed-rate loans because interest rates are low and they want to lock in at the low rate. If you have an Adjustable Rate Mortgage (ARM) now, refinancing with a fixed-rate loan can offer more monthly payment stability. If you have an Adjustable Rate Mortgage (ARM) now, we’d love to assist you in locking a fixed-rate at the best rate currently available.

There are many different types of Adjustable Rate Mortgages. Generally, the interest on ARMs are determined by an outside index. Some examples of outside indexes are: the 6-month CD rate, the one-year rate on Treasure Securities, the Federal Home Loan Bank’s 11th District Cost of Funds Index (COFI), or others.

Most Adjustable Rate Mortgages are capped, so they won’t go up above a certain amount in a given period of time. Some ARMs won’t adjust more than two percent per year, regardless of the underlying interest rate. Your loan may feature a “payment cap” that instead of capping the interest rate directly, caps the amount the monthly payment can increase in a given period. The majority of ARMs also cap your interest rate over the life of the loan.

ARMs usually start at a very low rate that may increase as the loan ages. You’ve likely read about 5/1 or 3/1 ARMs. For these loans, the initial rate is set for three or five years. It then adjusts every year. These loans are fixed for 3 or 5 years, then adjust after the initial period. Loans like this are usually best for people who anticipate moving within three or five years. These types of ARMs most benefit borrowers who will sell their house or refinance before the initial lock expires.

Why people choose a Adjustable Rate Mortgages?

Most people who choose ARMs do so because they want to take advantage of lower introductory rates and don’t plan on remaining in the house for any longer than this initial low-rate period. ARMs can be risky when housing prices go down because homeowners could be stuck with rates that go up when they cannot sell or refinance at the lower property value.

The Bottom Line
Only 10% of borrowers these days are choosing ARMs for home purchases according to Freddie Mac’s 30th Annual ARM Survey, released in January.