Adjustable-Rate Vs. Fixed Rates: Which One Is Better?

An adjustable rate mortgage starts out with some very nice rates, but that doesn't make it the right decision for many homeowners. See how to decide.

Page Summary

How to Decide Between a Fixed-Rate and an Adjustable-Rate MortgageWhen Brentwood homebuyers are first getting to know their mortgage options, they'll likely hear the terms ARM and fixed-rate over and over again. They're also likely to notice that one has more attractive interest rates than the other. But choosing between an adjustable-rate mortgage (ARM) and a fixed-rate mortgage is more than just considering the interest rates as they are now. Learn more about how buyers should approach their mortgage, whether they plan to stay in the home for 5 years or 5 decades.

For informational purposes only. Always consult with a licensed mortgage or home loan professional before proceeding with any real estate transaction.

How Adjustable Rates Work

Adjustable rates can change based on the market, making it possible for payment to rise and fall depending on the general strength of the economy. The index that each lender uses will be different, but the group setting the rates is a third party as opposed to the lender. Homeowners are provided with the information on the index the lender uses, so they can study the rates beforehand.

How Fixed Rates Work

As the name suggests, a fixed-rate mortgage provides one rate for the entire course of the loan. The principal, the interest, and the actual payments on the house remain the same. The idea behind these mortgages is that homeowners know exactly how much they'll be paying over time, so they can be certain it works into their budget.

The Temptation of the ARM

An ARM is highly tempting for many homeowners because the initial rates are lower than a fixed-rate. This benefit makes the mortgage payments lower and essentially opens the door to higher-priced properties in better areas. But there's a catch to this:

  • The lender is essentially hoping that the buyer will take a gamble. While an ARM could push their payments up significantly if rates rise, there's also a good chance (based on historical fluctuations) that their fortunes will swing the other way.
  • Some homeowners will benefit from an ARM if the rate continues to tumble. However, there are also homeowners who find themselves unable to keep up with rising mortgage payments.
  • We highly recommend using an amortization formula to calculate exactly how much the owner will pay on a home over time. Just keep in mind that an amortization formula can only predict interest rates rather than definitively state them.

The Course of the Loan

When homeowners are first crunching the numbers for both loans, it's easy to get lost in the sheer lifespan of the loan. Homeowners may rationalize their decisions because they'll be paying off the loan over the course of 30 years. But the savings (or the costs) of a tiny fraction of interest can be significant, and those numbers need to be taken into consideration. No matter how difficult it may be to swallow at first, homeowners are usually better off putting as much money as possible toward the loan rather than trying to find a loophole by extending the mortgage or betting on an ARM.

The Exception to the Rule

There is always an exception for certain homeowners, depending on their long-term goals. For example, let's say a homeowner finds a relatively affordable place in a very popular market. They want to live in the home while they own it, but they're not planning to stay any longer than two years.

An ARM can save money in the first few months, giving them additional disposable income to fix up their home. As long as the rates don't skyrocket in the very near future, they stand to make dramatic profits. Without the initial savings of the ARM, the homeowner may never have had the opportunity for such a successful investment.

The Power of Refinancing

The good news about deciding between an ARM and a fixed-rate mortgage is that nothing is set in stone. Owners do have the option to refinance if they feel they made the wrong decision. Whether owners want to switch from an ARM to a fixed-rate or vice versa, they can assess their amortization formula to determine the best way to save money. Refinancing has some serious initial upfront costs—up to 6% of the principal of the amount left on the home. However, as long as the homeowners are saving by at least 1% to 2% interest, the cost savings over time are usually enough to justify the decision.

The process of choosing one type of mortgage over the other involves more than just the honeymoon phase of homeownership. Owners have to consider how much they'll pay if rates go up while keeping in mind that those with ARMs over the course of several decades usually end up paying more than those with fixed-rates.

For informational purposes only. Always consult with a licensed mortgage or home loan professional before proceeding with any real estate transaction.

Posted by Gary Ashton on
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