If you’re in the market for a home, you must understand the differences between a Fixed Rate and an Adjustable Rate Mortgages and what those differences mean to you.
What is a Fixed Rate Mortgage?
A Fixed Rate Mortgage is a mortgage where the rate stays constant or “fixed” for the entire duration of the loan. Since the interest rate stays the same during the lifetime of the loan, the monthly payment also stays the same.
What is an Adjustable Rate Mortgage?
An Adjustable Rate Mortgage is a mortgage where the rate floats or “adjusts” above an index rate, such as the London Interbank Offered Rate (LIBOR) or US Treasuries. This means as the index rate rises and falls, the interest rate on the loan follows suit, so your monthly payments will increase and decrease along with it.
How do the payments differ?
Since a Fixed Rate Mortgage is set before the loan is funded, the lender must be compensated for future interest rate risk. Therefore, the rate on a Fixed Rate Mortgage will be higher than an Adjustable Rate Mortgage at the beginning. Lenders do this to protect themselves if rates increase throughout the life of the loan. The majority of each payment at the beginning of your fixed rate loan goes towards the interest versus the principal, but this changes throughout the lifetime of the loan. The final payments on a 30 year fixed loan are primarily principal, as opposed to interest like at the beginning.
On the flip side, an Adjustable Rate Mortgage will start out lower than a Fixed Rate Mortgage because the Adjustable Rate Mortgage will increase if the index rate it is tied to also increases. The risk involved for you is a higher future interest rate on your loan, which will increase your monthly payment.
What are the benefits of a Fixed Rate Mortgage?
Plain and simple, the rate is fixed, therefore the payment is fixed. When you get a Fixed Rate Mortgage you also get the comfort and security of knowing exactly what your mortgage payment will be for the next 15-30 years. If rates drop substantially, you can always refinance.
What are the benefits of an Adjustable Rate Mortgage?
With an Adjustable Rate Mortgage your rate and therefore payment, will be lower to start out than a Fixed Rate Mortgage. If rates drop in the future, your rate will also drop.
Which type of loan is better for you?
Whether a Fixed Rate Loan or an Adjustable Rate Loan is better for you depends on current conditions of the mortgage market and your investment plan. Current market conditions include the National Average Mortgage rate, bank and government incentives, plus a number of other national, regional, and local economic factors. Your investment plan must take into consideration how large of a down payment you can put down on a loan, future income, and longevity of your investment.