While the 30-year fixed-rate mortgage has historically been the most popular choice for homebuyers, interest in adjustable-rate mortgages, also known as ARMs, has been rising along with interest rates.
If you’re planning to buy a home this year, one of the most important decisions you’ll make (besides choosing the house itself) is which type of mortgage loan to use. A variety of factors, such as average interest rates, economic outlook, your personal situation, and more will influence your choice between fixed-rate or adjustable-rate mortgages.
In this comprehensive guide to fixed-rate mortgages and ARMs, we provide all the information you need to compare the pros and cons of both options and make the choice that is right for you. If you still have questions about your specific situation, our mortgage experts are here to help.
What is a Fixed-Rate Mortgage?
A fixed-rate mortgage has an interest rate that remains the same for the entirety of the loan term. If average rates rise, you’ll keep the lower rate that came with your mortgage. And if average rates fall, you can always refinance into a new fixed-rate mortgage.
Fixed-rate mortgages usually offer a choice of term lengths for 30, 20, 15, or 10 years. The longer your loan term, the more interest you’ll pay over the life of the loan. A shorter loan term will help you save on interest but your monthly payment amount will be higher.
What is a Variable-Rate Mortgage?
Also known as an Adjustable-Rate Mortgage (ARM Loan), a variable-rate mortgage has an interest rate that can fluctuate up or down depending on the index it’s tied to. Your monthly payment amount can also change with your interest rate.
Adjustable-rate mortgages were invented in the 1980s amidst record-high interest rates. Now that interest rates have been rising from their 2021 lows, an ARM loan could be an attractive option.
Terms for ARM loans vary, but they usually have an introductory period with a lower interest rate. After the introductory period, the rate can adjust up or down at certain intervals (such as once a year) and only by a certain percentage. If average rates rise, the rate on your ARM Loan will probably rise, too. And if rates fall, you can take advantage of this without going through a refinance.
To sum it up…
Essentially, fixed-rate mortgages provide more stability and predictability over the long run, whereas ARM Loans offer the trade-off of a lower initial rate in exchange for bearing the risk of changing rates over the long-term.
Let’s learn more about the features of adjustable and fixed-rate mortgages to help you decide which one is right for you.
8 Mortgage Terms to Understand
Navigating the mortgage application process is easier when you understand these industry terms:
- Adjustment Period - This is the amount of time between interest rate changes, which can happen every month, quarter, year, 3 years, or 5 years. You can tell the adjustment period by how the ARM is described - for example, as a "1-year ARM" or "3-year ARM."
- Annual Percentage Rate (APR) - This shows you the cost of borrowing money as a yearly rate that includes the interest rate, points, broker fees, and any other charges related to your mortgage.
- Balloon Payment - A larger payment due at the end of a loan term. The regular monthly principal and interest payments do not pay off the loan in its entirety.
- Buydown - This is when the seller pays your lender to get you a lower rate and payments during the initial period of your ARM loan.
- Caps - A cap is a limit. You may encounter the following kinds of caps with an ARM:
-How much your interest rate can increase with each periodic adjustment and over the lifetime of your loan.
-How much your monthly mortgage payment can change. - Discounted Initial Rate - This is the temporary, lower-than-average interest rate you may receive on an ARM loan for the fixed-rate, introductory period.
- Index Rate - Lenders use a certain index (a measure of interest rates generally) to calculate interest rate adjustments for your ARM loan. Popular indexes include:
- 1, 3, or 5-year constant-maturity Treasury (CMT) securities,
- Cost of Funds Index (COFI)
- London Interbank Offered Rate (LIBOR)
- Margin - Additional percentage points added to the index rate to calculate your periodic interest rate adjustment.
- Trigger Leads- Trigger leads are created by national credit bureaus. Once you apply for a personal loan or mortgage, your information can be sold by the credit bureaus to other lenders. You can learn how to opt out of them in this blog.
When to choose an ARM
Although adjustable-rate mortgages present a slightly bigger risk than a set-in-stone, fixed-rate loan, it’s best to balance out the risk versus the reward. You can use the “HAT” acronym to help you determine if an ARM is best for you.
High-Interest Rate Market
If you plan to move in a high-interest rate market, it might make sense to choose an ARM to take advantage of the lower introductory fixed rate and a possible rate decrease in the future.
Adaptability
Do you want to spend more time paying your mortgage principal at the beginning of your loan? Since ARMs start with a lower interest rate than a fixed interest rate loan, you can put those extra dollars towards paying down your principle.
Alternatively, if you need time to increase your earning and spending power, having a lower payment early on can give you the adaptability you need.
However, be sure you have enough room in your budget to accommodate a higher mortgage payment if your rate goes up.
Time
Are you a first-time homebuyer? Getting close to retirement? Planning on moving soon? If you are buying a starter home with the plan of selling in 5 years to purchase your dream home, nearing retirement and want to downsize, or if you know you’ll be relocating in 5 or 10 years, the amount of time you plan on spending in your home can influence your decision on a fixed vs adjustable-rate mortgage.
Are there any other big financial commitments in your near future, such as financing a car purchase or paying for a child’s college education?
When to choose a Fixed Rate
If the risk of an ARM outweighs the reward, you have a great option in choosing a fixed-interest rate mortgage. Choose between term lengths of 10, 15, 20, or 30 years. No matter the choice, the interest rate won’t change. This is a good choice if you:
- Plan on staying in your home for more than 7 years
- You are a first-time buyer who wants an easy-to-understand loan
- You are trying to stay on budget and want the comfort and predictability of a relatively steady payment for the life of the loan
- You are in a low-interest-rate environment and want to lock in that low rate for the life of your loan.
- You like to avoid risk in general.
- You’d like to mortgage a higher-value loan.
Finally, if interest rates fall, you have the option to refinance your fixed-interest-rate home loan. If you plan on being in your home for a long time, keep an eye on the interest rates and refinance as soon as the rates go down. If the difference in rates is big enough, you could even look at going from a 30-year term to a 15-year term, keeping your mortgage payment about the same and paying off the loan faster.
4 tips for choosing between a Fixed or Variable-Rate Mortgage
Still not sure which type of mortgage loan is right for you? Use these four tips to help you decide.
Tip #1: You can leverage the term of the initial interest rate to find the timeline and rate that works best for your situation. When setting a mortgage rate, lenders use benchmark rates, and the initial rate of an adjustable loan is lower than the benchmark percentage to attract borrowers. Generally, the shorter the introductory period, the lower the rate.
Tip #2: When shopping for an adjustable-rate mortgage, look beyond the initial interest rate to see what the total adjustments look like for the life of the loan. To see an overall picture, ask your lender to calculate the highest payment you may have to pay for their proposed ARM loan.
Tip #3: Don’t let the perceived unknowns of an adjustable-rate mortgage lead you to outright reject the possibility of securing an ARM loan. Use the HAT acronym to assist you in deciding.
Tip # 4: Although you will have a more predictable monthly payment for the life of your loan with a hard rate, keep in mind that as your property taxes and insurance rates fluctuate, so too will your monthly payment.
Where to get a Mortgage Loan
When it comes to choosing a mortgage lender, homebuyers have more options than ever, from traditional, brick-and-mortar banks to online lenders. However, it still pays to choose your local lender who lives and works in your community. Since our very first mortgage loan was approved, Peoples Bank has been committed to helping the people and businesses in our areas of service. All of our employees live and work, raise their families, and volunteer to strengthen our communities.
Questions To Ask About an ARM Loan
If you’re interested in an adjustable-rate mortgage, discuss these questions with your lender before making a final decision.
- How long does the initial or introductory rate last?
- What will my interest rate be after the introductory period?
- What will my monthly payment amount be for the first year?
- Including taxes, insurance (homeowners and PMI), HOA?
- How frequently can my interest rate adjust?
- Which index will my rate be tied to? What is the current index rate?
- What will the margin be on my ARM loan?
- What is the periodic interest-rate cap?
- What is the lifetime interest-rate cap? How high could the rate go?
- What is the most my minimum monthly payment could be after 1, 3, and 5 years?
- How low could the interest rate go on this loan?
- Is there a prepayment penalty?
- Is there a balloon payment?
- What are my origination fees and charges for this ARM loan?
Questions To Ask About a Fixed-Rate Loan
If you’re interested in a fixed-rate mortgage, discuss these questions with your lender before making a final decision.
- How much do I need to put down?
- Will I have to pay mortgage insurance?
- What is my interest rate?
- What is the APR?
- Do you charge for an interest rate lock?
- What will my monthly payment amount be?
- Is there an origination fee?
Get pre-qualified for a mortgage loan!
Whether you choose a fixed-rate mortgage or ARM, getting pre-qualified is the first step in your homebuying journey. Many real estate agents will want to see this letter before taking you on showings. It also makes you a more serious candidate in the eyes of sellers. Contact one of our lenders to start the pre-qualification process, apply online, or visit one of our locations in Rock Valley, Lester, Sioux Center, Akron, Sheldon, Hawarden, Hinton, & Sioux City, IA; Jasper, MN; and North Sioux City, SD. Peoples Bank offers conventional fixed-rate mortgage loans, ARMs, Construction Loans, Bridge Loans, HELOCs, and USDA loans.