When the time comes to start making choices about your home loan, one of the first decisions you’ll have to make is whether you’re going to finance your purchase with a fixed-rate mortgage or an adjustable-rate mortgage. Here’s the difference.
If you’re in the market for a home loan, the jargon tossed around can be a bit overwhelming. However, when you understand some of the basic terms, it can make the process feel a lot less stressful. So, let’s take a look at the difference between a fixed-rate and variable mortgage.
What Is a Fixed Rate Mortgage?
Of the two, the fixed rate mortgage is the easiest to understand. A fixed-rate mortgage is a loan with terms that stay the same for the entire duration of the loan. Your interest rate will stay the same from your first payment to your last, which also means your monthly payment will stay the same (or very close to the same.)
Many homeowners like having a definite payment plan, as it’s easier to budget every month.
Here’s an example of the kind of terms you might find in a fixed rate mortgage:
Loan amount: $250,000
Repayment term: 30 years
Rate: 4.6 percent for the entire repayment period
You take out a 30-year mortgage on a $250,000 home with a 4.6 percent interest rate.
Your first monthly payment would be (about) $1,282. If you made no extra payments and followed the repayment schedule your lender issues, your final payment (thirty years down the line) also would be $1,282.
Your total loan would cost you $461,380. That’s $211,380 in interest on top of the $250,000 purchase price.
What Is an Adjustable Rate Mortgage?
On the flipside, an adjustable rate mortgage, sometimes referred to as a variable-rate mortgage, features a rate that changes periodically during the life of the loan. Because the interest rate will adjust, that also means that monthly payments will change too.
An adjustable-rate mortgage (ARM) begins with a promotional rate period. The initial period can last anywhere from one month to five years (sometimes longer), depending on the specific terms of your loan.
Once that initial rate period ends, you enter an adjustment period. The adjustment period could be monthly, quarterly, annually, or every five years. During the adjustment period, your interest rate and your payment could go up or down.
So, for example, if you opt for a one-year ARM, that means your interest rate would change once per year until your loan is paid off.
ARM loans do apply interest rate caps to limit how much your lender can change your loan. The cap will limit the amount your interest rate can increase or decrease during your adjustment period and the total interest rate increase over the entire life of the loan.
Take a look at this example:
Loan amount: $250,000
Repayment terms: 30 years
Promotional rate: 3.6 percent for the first five years (ARM loans often have lower initial rates to entice customers)
Terms: Loan adjusts every year after the promotional period.
Your first monthly payment would be $1,136. If your interest rate increased by .25% every adjustment period, your last payment would be $1,610, and your total loan cost would be $501,339.
So, Which Should I Choose?
Unfortunately, there’s not a single best answer for everyone.
In our example from the previous two sections, the interest rates only increased, which makes the ARM about $40,000 more expensive. However, it is possible that your interest rate could decrease, making your loan less expensive than a fixed-rate loan.
Buyers who opt for an ARM loan are typically enticed by the lower promotional rates, which can be a full percent or more below that of a fixed-rate loan. The idea that home values could increase during the fixed period, allowing the buyer to refinance or sell their property before they must risk a higher interest rate can be alluring.
Many people also assume that they’ll be making more money in the future and be able to handle the increased prices after the promotional period and after interest rises.
However, the shifting market can be unpredictable, so it’s best to consider the worst-case scenario when opting for an ARM. What would happen if your home value didn’t increase as quickly as you wanted, and you were stuck in your ARM loan for the long-haul? What is the maximum monthly payment you would have to make?
Make sure you ask your lender to show you what could happen before deciding if whether an ARM is an affordable option.