When it comes to mortgages, borrowers overwhelmingly choose a fixed interest rate loan over an adjustable one. According to ICE Mortgage Technology, just 4.1% of all mortgage loans closed in September 2021 were adjustable-rate mortgages.
But that figure is almost double what it was in January 2021, when it was 2.3% of all mortgages, and as mortgage rates rise again after reaching historic lows during the coronavirus pandemic, ARMs may become even more popular.
If you’re planning to buy a home in the near future, it’s important to explore both fixed- and adjustable-rate mortgages and determine which one is a better fit for you.
[Read: Best Mortgage Lenders.]
How a Fixed-Rate Mortgage Works
A fixed-rate mortgage offers an interest rate that remains the same throughout the life of the loan. This means that your monthly principal-and-interest payment won’t change. Because fixed-rate mortgages provide more certainty than ARMs, they’re much more popular among homebuyers.
One thing to keep in mind, though, is that while the portion of your loan payment that covers principal and interest won’t change, your overall monthly payment can still fluctuate due to homeowners insurance premiums and property taxes.
How an Adjustable-Rate Mortgage Works
ARMs provide homeowners with a balanced approach to their mortgage interest rate. These loans typically have a fixed interest rate for a set period, which can range from three to 10 years, depending on the loan.
Once the fixed period is over, though, your rate will fluctuate based on market conditions. When you shop around for ARMs, you’ll typically see figures like 5/1 or 7/6. The first number refers to the number of years that the interest rate will be fixed, and the second number refers to how often the rate changes after that.
If the second number is 1, your rate will adjust every year. If it’s 6, your rate may change every six months.
Keep in mind that there are limits to how much your interest rate can change. Here’s some of the terminology you may come across as you compare ARM options:
— Initial cap. This is the maximum amount that an interest rate can change the first time it adjusts after the fixed period ends.
— Periodic cap. This limit is set for each adjustment after the first one. It may or may not be the same as the initial cap.
— Lifetime cap or ceiling. The lender cannot increase your interest rate beyond the lifetime cap or ceiling.
— Margin. Once your fixed period is over, the lender uses this predetermined percentage point amount to calculate your rate going forward. For each adjustment, the lender calculates your new rate by adding an indexed rate to the margin. As a result, your interest rate can never fall below the margin rate.
Historically, lenders have used the London Interbank Offered Rate, or Libor, as the indexed rate, but the Secured Overnight Financing Rate, or SOFR, is more common now.
“Because Libor was based on a panel of estimates provided by banks, it was subject to manipulation,” says Mike Tassone, co-founder and chief operating officer at Own Up, a service that helps borrowers evaluate mortgage lenders. “SOFR will be based on actual observable transactions in the overnight Treasury repo market.”
This difference in rate indexes is why SOFR-pegged mortgages adjust every six months while Libor-pegged mortgages only adjust once a year. Libor is a prediction of where rates will be in the future, while SOFR is an average of recent short-term rates. These averages go out of date faster, so they need to be updated more frequently.
Key Differences Between Fixed- and Adjustable-Rate Mortgages
As you compare adjustable- vs. fixed-rate mortgages, it’s important to understand how their differences can impact you and your budget. Here’s a quick look at some of these differences to help you determine which is a better fit for you:
|Fixed-Rate Mortgage||Adjustable-Rate Mortgage|
|Rate stays fixed for the life of the loan||Rate stays fixed for a period then adjusts regularly|
|Rate won’t increase if market rates go up||Rate will increase if market rates go up|
|Rate won’t decrease if market rates go down||Rate will decrease if market rates go down|
|Starts out higher than ARM rate||Starts out lower than fixed rate|
|Offers long-term predictability with payments||Offers short-term predictability with payments|
Who Should Consider a Fixed-Rate Mortgage?
If you’re considering a fixed- vs. adjustable-rate mortgage, here are some situations where it makes more sense to choose the fixed option:
— You’re planning to stay for a long time. If you’re buying your forever home, getting an interest rate that won’t change is likely the better choice. You don’t have to worry about changes to your budget, and you can rest easy with more predictable payments. “If they plan to stay in their home for longer than 10 years, the stability of a fixed-rate mortgage with its unchanging monthly principal and interest payments, especially with rates currently at historic lows, might be a better option,” says Brendan Phillips, senior capital markets associate at digital mortgage lender Better.
— Mortgage rates are low. At a time when market rates for mortgages are lower than usual, it may make sense to lock in a fixed interest rate, even if you’re not entirely sure how long you plan to stay in your home. At that point, rising interest rates may not be a matter of “if” but “when.”
— You don’t want to take on any risk. With an adjustable-rate mortgage, it’s the borrower who takes on all the risk of interest rates going up. So even if you think you may end up selling your home before the fixed period expires on an ARM, you may feel more comfortable with a fixed-rate loan, where the lender takes on that risk.
— You want a simpler loan. ARMs are more complicated, and those complexities can add more risk for borrowers who aren’t well-versed in how ARMs work. If you want a simpler loan, a fixed-rate mortgage may be better. “Because the rate and payments are fixed, the costs are known upfront, and it makes budgeting easier,” says Tassone.
Who Should Choose an Adjustable-Rate Mortgage?
As you consider the fixed-rate mortgage vs. adjustable-rate mortgage debate, here are some reasons you might want to choose an ARM:
— You plan to move soon. If you’re confident that you’ll sell your home before the fixed period on an ARM is up, you might as well take advantage of the lower interest rate compared with a fixed-rate mortgage. Even if you move a year or two after your fixed period expires, the savings you enjoyed during that time could still outweigh the cost of an increased rate for a short time.
— Mortgage rates are high. If mortgage interest rates are relatively high when you’re looking to buy a house, picking a loan with an adjustable rate could result in a lower interest rate over time instead of a higher one. While your rate won’t ever go below its margin, you could still save money over a loan with a fixed rate if rates go down. What’s more, you won’t have to go through the process or deal with the costs of a refinance to take advantage of those savings.
— You’re on a budget. Even if you’re not sure about when you plan to sell your home, an ARM offers a lower monthly payment during the fixed period.
— You want the flexibility. If you end up staying in your home longer than you initially thought, you can still refinance your loan into a fixed-rate mortgage to avoid rate fluctuations. There will be some costs associated with the refinance, but it can be worth it.
[Read: Best Mortgage Refinance Lenders.]
If you’re seriously considering an ARM, Phillips recommends getting as many details about the arrangement upfront. “Be sure to ask your lender questions like, ‘When is the soonest my rate could go up?’ ‘What are the caps on my rate changes?’ ‘How high could my rate increase?’ and more before applying for a loan,” he says.
Choosing the Right Mortgage for You
As you search for a mortgage to help you buy your next home, think carefully about your situation and goals. There’s no one-size-fits-all solution, so it’s important to know which is best for you and your budget.
Consider speaking with a financial advisor or mortgage professional who can give you some objective and expert advice on the matter.
Also, make sure you consider the various loan programs that are available. While ARMs are plentiful among conventional mortgage lenders, they may not be as common with certain government-backed loan programs — for example, the U.S. Department of Agriculture does not insure loans with adjustable rates as part of its rural loan program.
With the right approach and research, you’ll have an easier time picking the mortgage option that works best for you.
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Adjustable- or Fixed-Rate Mortgages: Which Is Better? originally appeared on usnews.com