Fixed or Adjustable?

Should you get a fixed-rate loan? Or an adjustable? Does it matter?

Answer: Yes, it totally matters.

One type you won’t think about much in a few years, even though it will save you money down the road. The other will save you money upfront, but could cause problems later on. Here’s a closer look.

Fixed-Rate Mortgages

First, let’s start with the crowd favorite: Fixed-rate mortgages. This is the go-to option for nearly 90% of homebuyers and loan refinancers. There’s a good reason for that popularity:

  • The interest rate stays the same and never changes.
  • Your monthly payment stays the same and never changes.
  • You don’t have to think about selling or refinancing in a few years, unless you want to.

Fixed-rate loans come in a number of flavors, with amortization terms from 10 years up to 30 years. However, two favorite loan terms account for most fixed-rate mortgages: 30-year and 15-year loans.

With the ever-popular 30-year fixed-rate mortgage, your interest rate and monthly payment are locked in for all 30 years.

Slightly less popular is the 15-year fixed-rate mortgage option. With this option you’re obviously paying for your home in half the time, so yes, your monthly payment will be higher. On the flip side, you’re paying off your home in half the time, so you’re saving serious cash and end up paying less lifetime interest.

Even though most people choose one of these two options, that doesn’t mean there aren’t others. Some borrowers prefer going with an adjustable rate mortgage (ARM).

All About ARMs

You can probably figure out that an adjustable rate mortgage comes with an adjustable interest rate. What’s that mean exactly?

In short, the rate for an ARM is tied to the interest rate of a specific financial index — Treasury bills, certificates of deposit, the LIBOR index, etc.

When that index goes up (or down), your interest rate follows.

Why would anyone climb on such an interest rate rollercoaster? Two reasons:

  • Introductory ARM interest rates are usually way lower than fixed-rate interest rates.
  • That low intro rate can let borrowers buy more house than they could with a fixed rate.

Most ARMs today are actually hybrids, with a low, fixed-rate introductory period followed by a rate that can adjust yearly based on its financial index. Some of the most popular ones are 3/1 ARM, 5/1 ARM, 7/1 ARM, and even 10/1 ARM, with three, five, seven, and 10-year fixed introductory periods, respectively. Most ARMs currently offered have long amortization periods, usually 30 years.

ARM Lingo

ARMs aren’t as simple as fixed-rate loans, which means they come with a mouthful of new mortgage lingo.

Here’s one way you might see an ARM offer listed out in the real world:

  • It’s a 5/1 ARM with a 3/2/6 cap with the interest rate determined by the LIBOR plus 2%

Wow. Let’s break that down.

  • This is an adjustable rate mortgage with a fixed rate for 5 years followed by a rate adjustment every 1 year. That very first adjustment is capped at 3%, later adjustments are restricted to a change of 2% or less per adjustment, and the lifetime interest rate cap for this loan is 6% over your initial rate, never more. This loan has a margin of 2%, meaning 2% is added to the base index, the LIBOR rate, to come up with your newly adjusted interest rate. See, not so hard.

So Which Is Better, Fixed or Adjustable?

Which is better? It depends. A 5/1 ARM offers the opportunity to save several thousand dollars in interest over the first five years, but those savings could be wiped out by a rate adjustment.

If you definitely plan to sell or refinance well within the introductory rate period, but could make higher payments if needed, an adjustable rate mortgage could be a good option for you.

However, if you plan to put down some roots or tend to worry about your future, sticking with a more conventional fixed-rate loan is probably the way to go.