How do fixed-rate mortgage loans work?
A fixed-rate mortgage is a type of real estate loan that has an interest rate that remains constant throughout the entire term of the loan. If you get a 30-year fixed-rate mortgage with a 6.5% interest rate, that's the rate that will be used to compute your interest in the first year, the 30th year, and all the years in between.
It's also worth noting that although your interest rate remains the same throughout the term, that doesn't necessarily mean your monthly housing payment will be the same. Most homeowners with a mortgage are required to pay a proportionate share of their property taxes and homeowners insurance along with their monthly payments, and these expenses can (and almost certainly will) change over time. But the principal and interest part of the payment will remain constant throughout your term.
As an example, if you get a $400,000 mortgage with a fixed interest rate of 6.5%, your monthly payment will be $2,528 for principal and interest for 360 months, plus whatever your taxes and insurance add to the payment at any given time.
How do adjustable-rate mortgage loans work?
As the name implies, an adjustable-rate mortgage (ARM) has an interest rate that can change over time. These are also referred to as variable-rate mortgages.
These loans typically have a relatively low initial interest rate that is guaranteed to stay the same for a certain period. Five years is common, as are seven- and 10-year initial rate periods. After the initial rate period, the loan's interest rate will reset, or adjust, according to a formula specified by the loan documents that is typically based on a benchmark rate, such as the prime rate.
Adjustable-rate loans are named by their initial term and how often they can reset. For example, a 5/1 ARM has a five-year initial rate period, and its rate will be adjusted every year after. A 7/6 ARM has a seven-year initial rate period and adjusts every six months thereafter.
With residential adjustable-rate loans, there are protections built into the loan that prevent it from adjusting too quickly. There's usually a maximum allowable adjustment at any one time, and there can be a ceiling that governs how high the rate could potentially go.
According to the U.S. Department of Housing and Urban Development (HUD), with FHA loans, five-year ARMs typically allow for increases of as much as 1 percentage point annually and up to 5 percentage points over the life of the mortgage, just as one example.
Fixed-rate mortgages: Pros and cons
The obvious advantage of a fixed-rate mortgage is that it keeps your payment consistent -- at least as far as the principal and interest portion goes. If your mortgage's interest rate increases by even 1 or 2 percentage points, it can have a big impact on your monthly payments. Using a fixed-rate mortgage avoids this risk.
It's also worth noting that fixed-rate mortgage loans can be refinanced, so they don't need to be avoided just because rates are elevated. If you get a fixed-rate mortgage loan with a 6.5% interest rate, and then rates proceed to fall to 5%, you can simply go to a top refinancing lender and refinance with a new loan. Legendary investor Warren Buffett has said that 30-year fixed mortgages are one of the best financial tools available to Americans because of this "one-way renegotiation" aspect.
The biggest negative is that you can typically get an adjustable-rate mortgage with a lower initial interest rate, so a fixed-rate loan will often have a higher monthly payment, at least for the first few years.
Adjustable-rate mortgages: Pros and cons
Adjustable-rate mortgages typically can be found with lower initial interest rates compared with fixed-rate loans, although this isn't always the case. As of February 2024, the average 30-year fixed mortgage rate is 6.64%, while the typical 5/1 ARM has an initial rate of 6.06%, according to Freddie Mac. Adjustable-rate loans have the advantage that their monthly payments are lower, at least at first.
The biggest negative of adjustable-rate mortgages is that there's no way to accurately predict what mortgage rates will do in the future. If the interest rate environment is higher when your loan adjusts, your monthly payment could increase significantly. While it isn't particularly likely that we'll see 10% or higher mortgage rates anytime soon, it is certainly within the realm of possibilities, and that could make your adjustable-rate mortgage far more expensive, especially if your ARM has a high cap on its interest rate.
Which is the best fit for you?
There's no perfect answer, and with an elevated interest rate environment and more consumer protections than they used to have, adjustable-rate mortgages can make good financial sense in some cases.
Generally, a fixed-rate mortgage makes the most sense if you're planning to stay in the home for at least five years. If rates fall, you can choose to refinance, but if they rise, you have the peace of mind of knowing your payment won't go up. On the other hand, adjustable-rate mortgages are generally best in situations where you are quite sure you won't be in the home for more than a few years, as you can keep your expenses low, but move on before the rate has a chance to reset.
