Mortgage Choices - Fixed Rate vs. Adjustable Rate

The variety and complexity of mortgage loans has increased steadily over the years. As a result, you have many more choices today than the mortgage shopper of ten years ago. In addition to the primary types of home mortgage loans, there are all kinds of specialty loans and "hybrid" options as well.

With that being said, there is one primary choice you will have to make when choosing a mortgage loan, and that is the fixed-rate versus adjustable-rate decision. So in this article, we will explain the differences between these types of home loans, the pros and cons associated with them, and the home-buying scenarios where they best apply.

Please note: This article is not meant to take the place of professional financial advice. Choosing a mortgage loan is a major financial decision, so you should seek professional guidance along the way. This article is simply meant to help you understand the differences between the two major types of home mortgage loans.

The Fixed-Rate Mortgage Loan

Without question, this is the most popular type of loan chosen by home buyers these days. As you might have guessed by the name, a fixed-rate mortgage keeps the same interest rate for the entire life or "term" of the loan. In other words, the interest rate will never change, regardless of what the economy does. And since the interest rate is the only component of a mortgage payment with the potential to change, your monthly mortgage payment will therefore remain fixed as well.

There we have the primary advantage of the fixed-rate mortgage loan. It keeps the same interest rate, and thus the payments never fluctuate.

Is there a downside to this type of home loan? Well, you will pay a premium for the long-term predictability offered by a fixed-rate loan, and that premium comes in the form of a higher interest rate (than what you might pay on a variable mortgage, as explained below).

The fixed-rate mortgage might be a good option for you if you plan to stay in the home for a long period of time. In this way, you can avoid the uncertainty of future interest rate hikes. Because no matter what the economy does, your interest rate will remain fixed.

These mortgage loans typically have a term or length of 30 years. That means the payments (including interest) are spread more or less evenly over a 30-year period. So the next time you hear the phrase "30-year fixed" mentioned by a mortgage lender, you'll know exactly what it means.

Summary of the Fixed-Rate Loan

§Interest rate stays the same over the life of the loan

§A good option if you will stay in the home for a long time

§Usually has a higher interest rate than an adjustable mortgage

§Most common length is the 30-year fixed mortgage

Now let's talk about the other common type of mortgage loan, one that has been in the news a lot lately.

The Adjustable-Rate Mortgage Loan

If you watched the news often during the mortgage crisis of 2007 - 2008, you probably heard this type of mortgage loan discussed quite a bit. That's because it had a lot to do with the foreclosure problems during that period.

But the adjustable-rate mortgage (ARM) is not, by itself, a bad thing. Most people who went into foreclosure as a result of their ARM loans did so because they failed to do the proper research into this type of loan, or because they failed to prepare for future changes in the interest rate.

With the proper education and planning, however, home buyers can use the adjustable mortgage to their advantage -- in certain scenarios, anyway. But before we discuss those scenarios, let's define this type of home loan.

As the name once more implies, the adjustable-rate mortgage has an interest rate that will adjust or "reset" at some future point in time. These days, the majority of ARM loans start off with a fixed rate for some initial period of time. For example, a 3-year ARM loan is one that starts off with a fixed rate for the first three years.

Typically, this initial rate will be very appealing to home buyers, because it's usually lower than the rate on a fixed mortgage loan. After that initial period, however, the interest rate will adjust. In most cases, this means a higher interest rate and thus a higher overall mortgage payment.

Of course, the key here is the amount that the interest rate will increase. But that's not something that can be predicted in advance, at least not with any certainty. This is what happened to many Americans during the aforementioned mortgage crisis. They chose ARM loans for the lower initial rate, and they were hit with significant rate increases at the adjustment / reset point. Many of these homeowners could not afford the larger mortgage payment that resulted, and thus went into foreclosure or sold their homes.

The best scenario for an adjustable-rate mortgage is one in which the homeowner will stay in the home for a short while. For example, if you knew for certain that you would only be in a home for three to five years, an ARM loan could save you money during those first years. And if you sold the home before the first adjustment / reset period, you would avoid any rate hikes.

Summary of the Adjustable-Rate Loan

§Interest rate is usually fixed for an initial period

§The rate will adjust or "reset" at a certain point, and then every few years

§The adjusted rate is typically higher than the initial rate

§Usually not a good idea if you'll be staying in the home a long time

§May be a good way to save money if you're only staying a few years

Conclusion

As mentioned at the start of this article, these are only two mortgage types of many. But most loans fall into one of the above categories, even if they are a hybrid of the two. So one of the first decisions you should make when choosing a mortgage loan is whether a fixed or adjustable rate will serve you the best. Think ahead as much as possible when making mortgage-related decisions, and seek the help of a financial advisor if necessary.

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