Fixed Rate vs. Adjustable Rate Mortgages
September 9, 2021
Whether you’re buying your first property or your fifth, a mortgage is a significant financial responsibility. Fortunately, it’s not particularly complicated. There are really only three major components of a mortgage that you need to compare when selecting which one is right for you:
- Term: the length of time over which you’ll be paying off the loan
- Amount: the total amount of the loan
- Interest rate: the interest charged on the loan
Interest rates on mortgages are amortized over the full term of the loan so that you pay the same amount every month, but that amount can vary if your interest rate changes. The interest on your loan will either be a fixed rate or a variable rate, each with its own pros and cons.
Advantages of Fixed Rate Mortgages
The main advantage of a fixed-rate loan is predictability. You’ll “lock in” a rate when you sign the paperwork on your loan, and that rate will apply for the rest of the loan’s term, regardless of external market forces. As a result, you’ll pay the same predictable monthly payment for the next 15 to 30 years.
The total amount of interest paid will depend on the principal and term of the loan. For example:
- On a $1 million loan at an interest rate of 3.5% over 30 years, you’ll pay a total of $616,560 in interest.
- On a $1 million loan at an interest rate of 3.5% over 15 years, you’ll pay a total of $286,788 in interest.
We’ve written in more depth about the pros and cons of 15- and 30-year mortgages here, but in either case, a fixed-rate loan means that your rate of interest and monthly payments won’t change.
Pros and Cons of Adjustable-Rate Mortgages
An adjustable rate mortgage (ARM) is considerably more complicated. The basic structure is that your interest rate will be fixed for a set amount of time at the beginning of the loan, usually at a rate much lower than the fixed rate you’d typically receive. After that period, your interest rate will change on a regular basis until the end of the loan. Some important terminology includes:
- Adjustment frequency: how often your interest rate is adjusted through the lifetime of the loan
- Adjustment index: your interest rate will typically be tied to an independent benchmark like the rate on Treasury bills, the Secured Overnight Financing Rate (SOFR), the Cost of Funds Index (COFI), or the London Interbank Offered Rate (LIBOR)
- Margin: on top of the adjustment index, you’ll pay a few extra percentage points. This might be expressed as “SOFR plus 2%” — if the SOFR is 0.5%, you’d pay 2.5% on your loan.
- Cap: typically, your bank will offer a cap on the amount that your interest rate can rise in a given adjustment period. Some loans will offer a cap on monthly payments instead, but any unpaid interest in this case is added to the principal of the loan, potentially leading to a loan on which you owe more than you initially borrowed.
- Ceiling: the highest number that your interest rate can reach during the lifetime of the loan.
During the initial fixed period, an ARM is typically much cheaper than a fixed-rate mortgage, allowing you to qualify for a larger loan. In an environment where interest rates are likely to fall, you might even benefit from lower monthly payments later in the loan.
That same volatility can work against you, though. If rates climb, your monthly payment could skyrocket in just a few years. The Consumer Financial Protection Bureau has taken steps to prevent predatory loans that might result in astronomical increases in monthly payment, but there’s still an inherent risk.
Is an Adjustable-Rate Mortgage Right For You?
There are a few situations where an ARM might present significant advantages:
- Falling interest rates: during economic booms, interest rates tend to rise. If you’re buying at what you think is a peak in interest rates, you might benefit from falling rates a few years down the road without needing to refinance.
- Short-term ownership: if you’re planning on living in your house for significantly less than the life of the loan, you might benefit from the lower introductory rate of an ARM and sell before rates go up.
- Higher future earnings: if you’ve recently graduated from med school, law school, or obtained an MBA, you’re likely to see a significant bump in income in the next few years. An ARM will allow you to borrow a higher amount at your current, lower income, and when your monthly payments go up, you’ll be able to afford them with your predicted future income.
- Early payment: if you have the cash on hand (or are likely to in the near future) to pay off your mortgage early, an ARM might be right for you. For example, you might buy a new house with a two-year ARM, sell your old house, and use the proceeds from your old house to pay off the remainder of the loan on the new house before the interest rate rises. You could also do the same with an inheritance or the sale of a business.
Talk to First Western Trust Bank
No matter what your situation, an ARM is something you should consider carefully before signing. At First Western Trust Bank, we can combine our in-depth knowledge of the state of financial markets and interest rates with a holistic examination of your personal finances and goals. The end result is a tailored recommendation and loan that’s right for your circumstances both now and years down the line. If you’re ready to start looking at mortgages, get in touch with First Western Trust Bank today.