Fixed Vs. Adjustable Rate Mortgages 

Understanding the difference between fixed and adjustable-rate mortgages is essential. Here is everything you need to know about the differences between the two to get the mortgage loan that is best for you. 

If you are about to buy a home right now, you are probably wondering about the difference between a fixed-rate and an adjustable-rate mortgage (ARM). A mortgage allows homeowners to finance the purchase of a home or property by repaying the borrowed sum over a set number of years. 

While repaying the sum, a borrower will pay the lender extra, which is where the loan type comes into play. A traditional fixed-rate mortgage is the most common among home buyers. However, ARMs are becoming more popular. 

Figuring out which rate is right for you will depend on the home price, your current market, and your financial standings. Both can come with a standard 30-year repayment option, require good credit, and can be refinancied. 

Keep in mind that there is no right or wrong answer, but one type of loan is most likely better for your situation. Before anything, you should learn how both types of loans can help you in buying a home. It may seem intimidating at first, but if you follow this guide, you will be relaxing in your new home in no time. 

Fixed and adjustable rate mortgages have their own benefits and drawbacks. Finding the right one for your financial situation is vital. This article will take you through the main differences, pros, and cons of each so you can make an informed decision. 

Consider these seven factors when deciding between a fixed and adjustable rate mortgage. 

1. How Fixed Rate Mortgages Work

A fixed-rate mortgage will have the same interest rate for the lifetime of the loan. Essentially, the monthly loan principal and interest payment will not change until you refinance. This is a great option for homebuyers who need a steady budget.

Once a borrower is approved for the loan, the interest rate will stay the same. The lender holds your property tax and homeowners insurance payments in an escrow account and pays them for you when they are due. However, the property taxes and homeowners insurance costs are outside of your lender's control. 

This type of loan comes in 30-year and 15-year terms. However, more flexible term options range from eight to 29 years. Keep in mind, the monthly payments may fluctuate due to property taxes and homeowners insurance premiums. These are likely bundled into your payments and can vary over time. The loan principal and interest will continue to stay the same. 

Most fixed-rate mortgages are amortizing loans; this means the monthly payments convert your principal and interest. Initially, most of your payments will be directed toward interest instead of the principal balance, which is the total loan amount.

The payment allocation will shift throughout the life of your loan, and you'll pay an equal amount in interest and principal. However, on an amortization schedule, you'll pay more principal than interest by the end of the loan's life. 

A fixed-rate mortgage allows homeowners to budget more easily. You won't have to worry about changing interest rates, which would increase your monthly expenses. This predictability is what draws the majority of homeowners towards fixed-rate mortgages.

2. How an Adjustable Rate Mortgage Works (ARM)

An adjustable-rate mortgage (ARM), will start off with a fixed-rate period. This introductory period is commonly three, five, seven, or 10 years. An ARM has an interest rate that changes at set intervals after this initial period.

On average, the initial interest rate will be lower than the standard fixed-rate mortgage. After this period, the rate can rise or lower at the predetermined times. Typically, this is every six or 12 months. Rate adjustments are dependent upon the stock market or financial index.

Remember that while ARM rates in the beginning will be lower, they generally rise after the introductory period ends. If the housing market goes through a drastic change, you could end up with substantially higher interest rates. Luckily, most ARMS have rate caps to protect you. 

An ARM could be the right choice if you are keeping the loan for a limited period of time and can afford potential increases in interest rates. There are three types of ARMS: 

Hybrid ARM: 

A mix of fixed and adjustable rate periods, starting with a fixed rate and then moving to change at a predetermined time. 

Interest-Only (I-O) ARM:

An I-O loan means you only pay interest on the mortgage for a specific amount of time, typically three to 10 years. After this period, you pay interest and the principal on the loan. 

Payment-Option ARM:

This type of ARM has several payment options, including payments covering the principal and interest, just the interest, or paying a minimum amount not including the interest. 

3. What is the Difference?

The most notable difference between a fixed-rate mortgage and an ARM is the variability of the interest rate. A fixed-rate mortgage allows you to pay a consistent amount each month. Meanwhile, with an ARM, the rate changes after the introductory period. Meaning that the payments will rise or fall with each reset. 

In addition to the predictability of interest payments, the initial interest rate of an ARM will be lower than a fixed-rate loan. If you cannot pay high rates in the beginning but know you will be able to later in the loan's life, then this might be your best option.

The down payment minimum will also be different. A conventional ARM requires a higher % down payment of 5%, and a fixed-rate loan has a 3% higher downpayment on average.

Finally, the way interest is calculated will vary depending on the loan type. With a fixed-rate mortgage, the rate is calculated based on your financial status. An ARM rate will fluctuate based on the moves of its benchmark index. In other words, when the loan is about to adjust, the new rate will be this index rate plus an extra percentage (margin) added by the lender.

The margin percentage will stay constant, and there are caps to ensure the rate can't just be above or below a set amount. 

4. What are the Similarities?

Both types of loans have some similar components. For example, both come with standard 30-year repayment options. According to CNBC, 89% of homebuyers applied for a 30-year mortgage in 2022. 

Additionally, both will require good credit to qualify for a mortgage. Similar to any loan, the lender has to assume a certain level of risk to loan you the money. You need good credit to get approved with the most favorable terms. 

The best and most important similarity of both loans is that they can be refinanced. Refinancing is the process of replacing an existing mortgage with a new one. The point is obtaining more favorable terms such as lower interest rates, lower monthly payments, and shorter or longer terms.

This means if you find that a fixed-rate mortgage or ARM isn't working for you anymore, you can change your loan without restarting the entire process. A good rule of thumb is if you are debating refinancing your mortgage, do it only if you can reduce your interest rate by at least 1%. This allows you to build equity in your home quicker. 

5. How to Choose?

Like many choices about homeownership and buying, there is no right or wrong answer. However, one type of loan might be a better fit for your financial status. 

A fixed-rate mortgage might be better if you are planning to stay in the home for an extended period of time. The stability means you won't have to worry about increasing payments, and you still have refinancing as an option.

A fixed rate is probably the better choice for a first-time homebuyer because it can be much more straightforward. An ARM has extra considerations and can be daunting. Additionally, most first-time homebuyer loan programs only come with a fixed-rate option. 

On the other hand, an ARM might be best if you know this isn't your forever home. If you plan on moving in the coming years, you could save money from the intro payments, which are typically low. 

This also applies to homeowners with foreseeable lifestyle changes. If you can count on a major rise in your earnings over time, you will be able to handle any rate and payment increases. 

Finally, if you are buying when interest rates are high, an ARM may be the better option. By the time the ARM changes, interest rates may be going down. While predicting the housing market can be hard, keeping an eye on the market conditions and predictions will be invaluable while making this decision. 

FAQ: Fixed Vs. Adjustable Rate Mortgages

Here are some commonly asked questions about fixed and adjustable rate mortgages.

Why would a person choose a fixed mortgage over an adjustable-rate mortgage?

A fixed-rate loan will make it easier to create and stick to a budget. In turn, this makes it easier to plan your future because you know exactly how much you will be spending on the loan each month. 

Are ARM loans a good idea in 2024?

ARM loans are becoming increasingly popular. However, they are best when rates are likely to drop by the time you adjust. Before acquiring an ARM loan, you should research the current and future market conditions. 

Can you refinance an ARM loan?

You can refinance an ARM loan by replacing your existing mortgage with a new one. This allows you to replace it with another ARM or switch to a fixed-rate mortgage. 

What percentage of Americans have adjustable-rate mortgages?

Approximately 40% of Americans have mortgages; out of this, 92% have fixed rates, and the remaining 8% have adjustable rates, according to the Federal Reserve Bank of St. Louis. 

How do I get out of my ARM loan?

In order to get out of a loan, you'll need to refinance. Refinancing an ARM loan is similar to refinancing a fixed-rate mortgage. You have to qualify and apply for a new mortgage and use that to pay off the ARM. In addition, you can refinance with different types of new mortgages, like a 20 or 30-year mortgage.

Methodology

We used information and data from several different sources, as well as our own data, to determine everything you need to know about fixed and adjustable-rate mortgages. Most of the data was sourced from the following sources:

• The Federal Reserve Bank of St. Louis
• CNBC

Fixed Vs. Adjustable Rate Mortgages - Final Thoughts 

The right loan for you may change with the market. Luckily, if you find your loan no longer suits your needs, you can refinance. Refinancing your loans is meant to lower your monthly payments. Before making any big decisions, carefully look over your current mortgage, market trends, personal budget, and long-term financial goals. 

No matter which type of loan you opt for, you should check in with a loan professional or trusted real estate agent to ensure this is the right decision for you. It is recommended to keep an eye on current rates, as they are everchanging and you may have a chance to get a better rate in the future. 

As you search for your next home, Raleigh, NC, is one of the fastest growing areas in the country, with many stunning neighborhoods to choose from. Feel free to contact one of our helpful real estate specialists, as they are eager to help you find the perfect home. Buying a home can be overwhelming, but a trusted agent can walk you through the entire process.