Fixed Rate vs. Adjustable Rate: Pros & Cons
Breaking Down the Pros & Cons of Fixed Rate and ARMs
Determining how much your monthly mortgage payment is – and if you can afford it – is always front and center when preparing to purchase or refinance a home. This payment amount comes down to the three aspects of borrowing: the size of the loan, the term or length of time the loan will span, and the interest rate.
How much you borrow will be the difference between the purchase price and your down payment, or if refinancing, the amount is how much a lender will allow based on the value of your home and existing mortgage – or loan-to-value ratio. The longer the term, the smaller your monthly payment, and lastly, the interest rate is added to the loan to pay the lender for covering the mortgage.
Interest rates are very low right now thanks to the Federal Reserve, but they’re also influenced by your credit standing, the amount of down payment, and more. While there are multiple types of mortgages and refi programs, the interest rate is applied in two ways – fixed rate or adjustable rate. Let’s look at the pros and cons of each.
What is a Fixed Rate Mortgage?
The most common type of loan is the fixed rate mortgage which is exactly what it sounds like: the interest rate will not change for the life of the loan. While the proportions of principal and interest will shift over time due to amortization, the monthly payment is stable and predictable, regardless of the market or the economy.
The upside of the fixed rate model is that it’s clearly easier for homeowners to budget. They know what to expect every month and can plan accordingly. They can increase their payment when feasible to reduce the principal and shorten the term. The downside may be the difficulty of getting financed when the rates are higher, pushing monthly payments up as well.
Also impacting your monthly payment is the term, or length of the loan. The most well-known being the 30-year, fixed rate mortgage. In addition to a low interest rate, the longer term will result in more affordable payments. A shorter term loan would mean higher monthly payments, but less interest accrued over the life of the loan will save thousands in the long run. Lenders like EnTrust Funding (ETF) typically offer alternative terms of 10, 15, or 20 years.
What is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage – referred to as an ARM – has a variable interest rate that can go up or down during the life of the loan. Although this may not seem as practical as a fixed-rate mortgage for predictability purposes, it can be an astute choice depending on your goals and borrowing circumstances.
An ARM will start off with an interest rate that’s often significantly lower than the standard fixed rate, saving you money up front on your monthly payments; however, these mortgages are more nuanced. At predetermined terms, the rate will be adjusted based on benchmarks from interest rates on specific assets such as Treasury bills or CDs. These variables will be scheduled to occur anywhere from a month to ten years, and the rate resets based on market rates. There are also different frequencies at which the rates will reset – such as after 3, 5, or 7 years.
Safeguards for the borrower are put into place in the form of caps and ceilings. A cap is the limit on how much the interest rate can rise during the adjustment term, and a ceiling refers to the max-out point for the rate during the life of the mortgage.
The pitfalls of the variable rate mortgages were well-publicized during the housing crash when borrowers were not prepared for sky-rocketing monthly payments. Regulations have since been put into place to prevent a repeat, but it’s wise to familiarize yourself with the reset schedule and potential rate increases. If you’re looking for predictable payments and you don’t plan to move for many years, an ARM may not be the best solution for buying or refinancing.
Refinancing from One to the Other
When you’re talking fixed-rate vs. adjustable-rate mortgages, you have to acknowledge how compatible they can be when it comes to refinancing. If you’ve enjoyed the benefits of initial low rates on an ARM, but a reset period is approaching with the promise of an increase to your monthly payment, then it may be a good time to refinance to a fixed-rate loan. This is especially true if you plan to stay in the home indefinitely and don’t want an unpleasant surprise.
The reverse comes into play if your current fixed-rate loan was taken out when rates were higher, and you know there’s a move in your future. Refinancing from fixed to variable can reap added savings in the short term if you plan to relocate before the next increase.
What’s Right for You?
With either refinance decision, be sure to do the math and include potential closing costs and fees, current rates, and economic predictions. Then you can determine which interest rate format will garner you the lower monthly payment, and for how long. The lenders at EnTrust Funding can discuss your financial goals, help calculate your term, rates, and monthly payments in order to get you qualified for the best mortgage for you and your family. Contact us today to learn more.