When you hear about savings of more than $15,000 over the course of five years with an adjustable-rate mortgage, it’s hard to ignore. With that said, before making the decision to borrow with an adjustable-rate mortgage instead of a fixed-rate mortgage, you should consider the pros and cons of each home loan.
Many Americans benefited from the low interest rates offered at the beginning of the pandemic by refinancing or opting for a fixed-rate mortgage. Now that interest rates set by the Federal Reserve are rising, adjustable-rate mortgages are gaining popularity once again.
When you’re working with a lender to find a mortgage loan for the home of your dreams, you’ll likely hear both options and a lot of other information about the loan terms. We’re breaking down the differences between the two primary mortgage options to help you decide which option is best for your investment in a home.
What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage or ARM is a loan type that carries a fixed interest rate for a specified period (called the fixed period) but then fluctuates thereafter. They’re typically 30-year loans, but this varies. It’s common for the initial interest rate to be lower but later it may increase (or even decrease) given the market conditions. The interest rate changes can occur at different time intervals (called adjustment periods), depending on what was established at the time of accepting the loan.
For example, a 5/1 ARM means that you would pay a fixed interest rate for the first five years, followed by adjustments to the rate every year. Another example is a 10/6 ARM, where you’d pay the fixed interest rate for ten years, but the rate would fluctuate every six months after those ten years. A popular choice for homebuyers is a 10/1 ARM.
How Is a Fixed-Rate Mortgage Different From An Adjustable-Rate Mortgage?
Just as the name suggests, a fixed-rate mortgage is a home loan with a set interest rate that lasts for the loan’s duration (or term). A borrower’s interest rate will remain the same as will the principal payments each month. The stability of a fixed-rate mortgage is what makes them the most popular option in the U.S.
The benefit of this type of mortgage loan is that market fluctuations cannot impact the rate that was initially offered, unlike the later years in an adjustable-rate mortgage. It’s easier for homeowners to budget their monthly expenses over the years and plan for the future.
The Pros and Cons of an Adjustable-Rate Mortgage
You pay a lower interest rate in the beginning
When current interest rates are high, an adjustable-rate mortgage allows homeowners to secure a lower rate than the market because of the nature of this type of loan. This is one of the main reasons it’s appealing given the current market. The lower interest rate makes it a little easier to afford a home for the first five to 10 years, whereas a high interest can be a barrier to entry for some people.
The adjusted interest rate could be lower than current rates
Although this is not guaranteed, an adjustable-rate mortgage could offer lower interest rates than the current market once it adjusts after the fixed term. This means even more savings than a fixed-rate mortgage which is locked in for the entire 30 or 40 years of the loan. Once you enter the adjustment period of the loan, your interest rates could change as often as every six months.
In a low-interest rate market, you’re likely to receive even lower rates, but in a high-interest rate market, you may experience higher interest rates than the current market. The silver living is that there are caps on how high your rate can increase during each adjustment, much like rent control in expensive cities.
ARMs are smart for short-term homeownership
Due to the nature of an ARM having a low interest rate initially, they can be a wise choice for someone who plans to sell their home before the first adjustment period occurs. It’s important to consider your long-term goals when selecting an ARM. You could opt for a five year or 10-year fixed period, allowing you to budget accordingly before ever entering the adjustment period.
Future higher payments could be difficult to manage
Just as the initial low payments are a pro of an ARM, the later payments can be a con if your rate increases in the adjustment period. It’s not as easy to plan for given the market fluctuations, so it’s important to have a buffer of savings in case this occurs. You could end up in a tight financial situation if not.
Additionally, the rate caps set by your lender also vary, so comparing options when selecting this type of loan could help you plan. You can at least have an idea of the highest rate increase you might experience and set money aside for the worst-case scenario.
Your financial stability could change in the future
Job loss, job changes, and economic impacts to a company can all affect the monthly income you rely on, thus affecting your ability to make monthly mortgage payments. In those situations, you may have a tough time keeping up with your monthly payments if you opted for an ARM because of the fluctuating rates.
The higher interest rates may exceed your monthly income, or a decrease in your salary could mean you’re unable to match the rates you’ve budgeted for every month unlike a fixed-rate mortgage.
Paying a prepayment penalty when your sell or refinance
If you decide to refinance your adjustable-rate mortgage to secure a lower interest rate, there is a potential for a prepayment penalty. A prepayment penalty, or early payoff penalty is a fee you must pay for the loss of potential interest that the lender experiences. This is not likely, but ask your lender when discussing the terms of the loan.
Compare Both Options and Consider the Market
As mentioned earlier, both adjustable-rate mortgages and fixed-rate mortgages have their pros and cons. It’s important to think through your long-term homeownership goals, assess your finances, and discuss the options with your lender.
Favorable mortgage loan terms could mean that one options works better than the other. You can also negotiate the terms of the loan with your lender to fit your needs as a homebuyer. Do your research, compare the pros and cons, and come to the table prepared for the conversation.
Also, keep in mind that regardless of the loan type you choose, if mortgage interest rates decline you may be able to refinance and save money.