As homeowners search for the perfect house, they should also look for the right type of home loan to pay for their dream living space. In researching your loan options, you have the choice of a fixed-rate or adjustable-rate mortgage. Which one you choose could impact your ability to afford your mortgage payments and how much you will pay over time.
Here is a breakdown of the two to help you determine which is right for you:
What is a Fixed–Rate Mortgage?
Like the name suggests, the interest rates of the fixed-rate mortgage will not change over the life of the loan. With fixed-rate mortgages, there are different time periods set for how long you are expected to pay off the loan. A 30-year fixed-rate mortgage is standard for homeowners with the payments split between 360 months. There is also the option for 10-year and 15-year fixed-rate mortgages. The rates will depend on your creditworthiness as well as the purchase price of the house and the down payment provided.
While a fixed-rate mortgage allows for more stability for homeowners, there are pros and cons to this type of loan. Take for example, a loan amount of $250,000 for a 30-year fixed-rate mortgage at an interest rate of 4.5 percent per year. For this particular loan, you could pay a monthly mortgage payment of about $1,267.
Advantages of a Fixed-Rate Mortgage
- Payment remains the same. When you are paying a mortgage, you will have other bills that will also need your attention. Having a fixed-rate mortgage could be beneficial as you will know exactly how much in mortgage payments you owe each month, which could allow you to budget for other expenses accordingly.
- Interest rates do not change. After you lock in your interest rate with a fixed-rate mortgage, the rate is expected to stay that way over the time of the loan. This could allow you to better afford your mortgage even as interest rates in the market increase.
- Total interest paid is higher. If you plan on staying in your home for a long time, a standard 30-year fixed-rate mortgage might be the loan of choice. However, while payments will stay the same, the total interest you will pay will be higher than a shorter-term loan. With the example monthly mortgage payment above, of the total paid over the life of the loan, 45.18 percent will be in interest with $206,000 compared to $250,000 paid with the principal.
What is an Adjustable Rate Mortgage?
Unlike a fixed-rate mortgage, an ARM's interest rate will change over time. There are different types of ARMs, including a hybrid mortgage, which is one of the most popular options. Hybrid mortgages state that the interest rate will remain the same for the initial period and then it will adjust once per year for the remaining loan period. Usually, for your hybrid mortgage terms, the time periods when payments will be the same could range between five to 10 years. However, after that period, the interest rates will move depending on the U.S. Treasury rate.
Advantages of an ARM
- Interest rates smaller than fixed-rate. When looking at both fixed-rate and ARM, you could consider the smaller interest payments associated with adjustable rates during introductory periods. The lower interest rates will also help you qualify for approval if the house you have your eye on is a higher price.
- Lower payments for the initial payment period. With an ARM, homeowners could actually pay a lower interest rate compared to a fixed-rate mortgage in the initial period when the rate stays the same. This could make mortgage payments more affordable as homeowners are still trying to juggle various household payments along with their home loan.
- Flexibility to sell or refinance. Since there is a smaller interest rate with an ARM than with a fixed-rate mortgage, homeowners have the ability to move on the next stage of homeownership, which could involve either refinancing for a lower interest rate or selling the property after fixing it up.
- Potential interest rate fluctuations in the future. While ARM interest rates may be lower than fixed-rate mortgages, there is also the risk that interest rates will continue to grow in the future. This could change your ability to afford your home depending on how much rates increase as well as if your income stays the same. Whether or not this happens, your mortgage payments could actually expand in the future.
Questions to Ask Yourself
As you look into both options, there are some questions you could ask to help you decide which one is better.
Here are a couple of questions to ask:
- Will your income increase during the loan period? During this time, consider whether you are more likely to afford a fixed-rate or ARM. If you believe your income will rise during your mortgage period, then you could choose an ARM. On the other hand, if you think it will stay the same, then you could prefer a fixed-rate mortgage since your payments will not look different as the years go on.
- Are you willing to take on some risk? Since there is some level of risk associated with ARMs as the interest rates could rise, consumers should ask whether they are willing to take it on. If you are unwilling to do this, then a fixed-rate mortgage could be for you.