Which is Better, a Fixed Rate or Adjustable Rate Mortgage?Which is the better mortgage, a fixed rate or an adjustable rate mortgage (ARM)? Well, that depends on your goals for the loan and your tolerance for potential interest rate increases in the future. The advantage of an ARM is that the interest rate can often start off much lower than a comparable fixed rate mortgage. This can mean a much lower payment and lower interest costs compared to a fixed rate mortgage. However, this also comes with the risk of possible payment increases in the future if interest rates rise. So which is better, fixed or adjustable? Let me give you a few things to think about.
The Longer the Fixed Period, the Higher the RateWe all know there’s no free lunch out there, right? This is as true in the mortgage industry as anywhere else. Here’s a good rule of thumb to remember when evaluating various mortgage options: the longer the fixed period, the higher the interest rate on the loan. This is why the 30-year fixed mortgage usually has the highest interest rate out of all comparable loan options. The bank is shielding you from interest rate increases for the entire 30-year life of the loan, so they’re going to charge the maximum interest rate premium in exchange. These are the most common fixed and adjustable 30-year term mortgage products you’ll likely come across:
|Common Adjustable Rate Mortgages|
|ARM Type||Years Fixed|
|1/1 ARM||Adjustable for the entire life of the loan.|
|5/1 ARM||Fixed for five years, then adjustable for the remaining 25 years.|
|7/1 ARM||Fixed for seven years, then adjustable for the remaining 23 years.|
|10/1 ARM||Fixed for ten years, then adjustable for the remaining 20 years.|
|30-year fixed||Fixed for the entire 30-year term.|
As you go down the list from top to bottom, the interest rate tends to get higher because the fixed period gets longer. Again, the bank charges more if they’re going to shield you from interest rate fluctuations for longer.
How Long Do You Plan to Keep the Loan?When evaluating loan options, the key question is this: how long do you plan to keep the loan? An ARM can make a ton of sense if you know you won’t be keeping the loan for the entire 30-year term. After all, why pay for the security of a 30-year fixed rate if you know you won’t use it?
For example, if you plan to keep the loan for only 5 to 7 years (perhaps you plan to sell the home or pay off the loan in that time), a 5/1 ARM could be a great option. The interest rate can be more than 1% lower than a 30-year fixed and you’re not going to be in the loan long enough to risk substantial rate increases. Depending on the loan amount, the lower rate could make a huge difference in your payment and the cost of the loan over time.
If five years is a little too short, you might consider a 7/1 or 10/1 ARM. The interest rate will be slightly higher than a 5/1 ARM, but still better than a comparable 30-year fixed.
If you do decide to consider a 10/1 ARM, have the lender price out a 30-year fixed loan as well. Rates on 10-year ARMs can sometimes be very comparable to a 30-year fixed, so it might just make sense to go with a 30-year fixed.