Fixed Rate vs. Adjustable Rate Mortgage Loans

Whether you’re looking to buy a new home or remodel an existing one, you will need a loan. Homebuyers had only three mortgage loan types to consider in earlier times. The fixed-rate conventional mortgage, an FHA loan, or a VA loan. Nowadays, there’s far more to choose from, and if you don’t understand the subtle differences between them, it can be hard to know which to pick. So we discuss the difference between Fixed vs. Adjustable Rate loans, Jumbo vs. Conforming Loans, and others.

The fact is, there is no one size fits all loan type. However, your financial situation and home-ownership needs will help point you in the right direction. Here are the most common loan types and what they cover to make things easier.

Deciding Between Fixed-Rate vs. Adjustable Rate Loans

When deciding on the mortgage loan type, you’ll have to make one of the first choices whether you want a fixed-rate or adjustable-rate mortgage loan. Every loan fits into these two categories or a “hybrid” combination. These are the main differences between them, and as you’ll see, both choices have pros and cons that must be considered carefully.

Will you choose a fixed-rate mortgage or an ARM? And what do these terms mean anyway? Read on to understand your loan options better.

• Fixed Rate – The interest rate, in this case, is locked for the entire duration of the repayment term. So, month after month, year after year, your monthly payment will stay the same. However, you will pay a higher interest rate than the initial ARM rate for this stability.
• Adjustable-Rate – An adjustable-rate mortgage loan (ARM) has an interest rate, which will change over time. In most cases, the change will come once every year after an initial period of remaining fixed. For example, the 5/1 ARM loan starts with a fixed interest rate for the first five years. After that, it will adjust each year. The main benefit of an ARM loan is that the initial interest rate and monthly payments are lower than a fixed-rate loan. But it comes with the uncertainty of changing interest rates in the future.

What is a Fixed-Rate Mortgage?

A fixed-rate mortgage loan type is one with a fixed interest rate for the life of your loan. This fixed rate also means that your monthly principal and interest payments won’t fluctuate. Fixed-rate mortgages generally last 15, 20, or 30 years.

Why Choose a Fixed-Rate Mortgage?

The most significant advantage of fixed-rate mortgages is their predictability. While they can be more expensive than ARMs, homeowners love knowing what they’ll be expected to pay each month, particularly in the establishment.

They’re a desirable option for people who intend to live in their homes for at least seven years, which is the time when fixed-rate mortgages can start becoming less expensive than ARMs.

Fixed-rate mortgagors also find budgeting easier because they always know how much they’ll need for home repayments. And if inflation soars, people on fixed-rate mortgages can feel confident that they won’t lose their homes. Even people with a fundamental understanding of finances can grasp fixed-rate mortgage loan types. That makes them an excellent option for homeowners who prefer to keep things simple.

What is an ARM?

The ARM is short for an adjustable-rate mortgage. When you enter an ARM, its interest rate will be generally lower than a comparable fixed-rate mortgage for an introductory period of five to seven years. After this period, the market index will determine your interest rate. Interest rate caps help protect homeowners from substantial interest rate shifts. ARMs generally last for 15, 20, or 30 years like fixed-rate loans.

Terms You Should Know

Although there are different varieties, you will often see an ARM quoted as 3/1, 5/1, 7/1, and 10/1. The first number represents how long the initial rate will be in place. For example, in a 5/1 ARM, this introductory rate will not change for five years, typically lower than a fixed interest rate. The second number indicates how often the interest rate is adjusted annually in this case.

You will next need to understand what index it is based on. We mentioned two above – LIBOR and the Treasury rate. After the initial period expires, a margin will be added to this rate, which would also be prudent.

There are three more fundamental concepts: initial cap, periodic cap, and lifetime cap. As the names suggest, these limit how much your rate can go up. The first cap is how much the mortgage rate can increase when the first adjustment (e.g., in a 5/1 ARM, it would cap the amount the new interest rate can rise after five years.) The periodic cap limits the increase for each subsequent time it can be adjusted, while the lifetime cap sets the maximum amount the interest rate can increase over the life of the loan.

These are important in understanding to compare different ARMs accurately. For example, unlike a fixed-rate mortgage, an equal initial rate between lenders can have other consequences.

Why Choose an ARM?

The low initial rate of an ARM can be very enticing to new homeowners. While there is a risk of higher payments later, many homeowners feel they’ll be better able to afford these payments in the future when their job may be more secure, or they’ve completed renovations. The lower repayments can even help families buy larger homes than they might afford on a fixed-term loan. Alternatively, an ARM can free up cash for people who’d prefer to build an investment portfolio rather than sinking a lot of money into their mortgage.

Financial markets rise and fall, and people on ARMs benefit from lower payments when they fall. In contrast, people on fixed-rate mortgages must refinance their homes and pay thousands of dollars in closing costs and fees to take advantage of housing market shifts.

ARMs are also an excellent option for people who plan to move houses within a few years. They can enjoy their honeymoon and sell their property before risking higher payments.

The decision about which mortgage to accept is big, but you’ll feel confident about making the right choice once you understand your options.

Final Thoughts on Fixed Rate vs. Adjustable

The Federal Reserve held short-term interest rates near 1% and may hold off for the rest of the year. If that’s the case, your adjustable-rate will likely not adjust upward for several months. Doing your homework and understanding how high your rate can go is essential.

What are the Different Types of Home Loans?

Government Issued vs. Conventional Loan Types

So, once you know whether you want a fixed or adjustable-rate loan next, you’ll want to consider whether you want a government-backed or conventional loan.

• Conventional Loans – These are loans from mortgage lending institutions that the government’s agency does not back. Different from FHA and VA loans.
• FHA Loans are the most common loan choice for first-time buyers, but it’s also available to all other buyers. The Federal Housing Commission (FHA) is an offshoot of the Department of Housing and Urban Development (HUD), part of the federal government. Through this, the government ensures the lender against any losses resulting from the default. What’s great about this loan is that your down payment can be as low as 3.5% of the purchase price. The downside is that you’ll have to take out mortgage insurance, which will increase the size of your monthly payments.
• VA Loans – Military veterans and their families may qualify for this program through the U.S. Department of Veteran Affairs. As with the FHA loan, the government will reimburse the lender for any damages resulting from the default. The difference with the FHA is that the down payment is 0%. That’s right; the borrower receives 100% financing.

Secured vs. Unsecured Loans

Another distinction between loans is that they can be secured or unsecured.

• Secured Loans – Most loans are of this type and designate a loan covered by collateral such as your house or car. The property’s value and credit history determine how much you qualify for and the interest rate. In default, your property will be transferred to the lender.
• Unsecured Loans – As the name suggests, an unsecured loan is not backed by collateral. Instead, your credit history and loan amount determine the interest rate and loan amount. This can be a good option for those with a good income, excellent credit history, and a solid paycheck.

Jumbo vs. Conforming Loans

How much do you wish to borrow? Put your loan in one of two categories.

• Conforming Loans – To meet the criteria for a conforming loan, it must meet the underwriting guidelines of Fannie Mae or Freddy Mac. These are two government-controlled corporations that buy and sell mortgage-backed securities (MBS). The primary guidance is the maximum loan amount.
• Jumbo Loans – Any loan that doesn’t meet the guidelines of Fanny Mae or Freddy Mac is a non-conforming or jumbo loan. Because its size presents a much more significant risk for a lender, usually, you’ll need excellent credit and make a sizeable down payment to secure one.

Open-ended vs. Close-ended Loans

One final distinction between loans is whether you’re borrowing to finance a home purchase or renovation.

• Open-ended Loans – This is a mortgage loan type with a fixed-limit line of credit that you can borrow from again and again. A credit card is one example of an open-ended loan. Another example is a home equity line of credit (HELOC). Based on a percentage of your home’s appraised value, the lender approves you a certain set amount. It allows you to borrow and pay back over time quickly. Homeowners going through a renovation project find this very useful.
• Close-ended Loans – Mortgages, car loans, and student loans fall into this category. When more credit is needed, you must take out another loan type. You are approved for a set amount and can now borrow again.