When you take out a mortgage, you not only choose a loan program, such as conventional or FHA, but also the type of interest rate: fixed or adjustable (ARM). For both options, you borrow money to buy a home, but how they affect your monthly payment and total interest paid is different.
What’s a Fixed-Rate Loan?
For a fixed-rate loan, you lock in the interest rate once you’re approved, and it remains your rate for the life of the loan until you pay it off in full or refinance. Fixed-rate loans are subject to the current rates, but you can also pay discount points if you want to lock in a lower rate than what’s available at the time.
How Does it Work?
With a fixed-rate loan, your rate doesn’t change, but the amount of principal and interest you pay does. At the start of your loan, your payment consists of more interest than principal because of the higher balance. As you pay down the loan, the interest charges decrease, and as you near the latter half of the loan, you pay more principal than interest.
Who Should Choose a Fixed-Rate Loan?
Fixed-rate loans are best for borrowers who know they’ll be in a home for the long term. Because they offer predictability, it can be reassuring to know how much your rate will be for the next 30 years.
What’s an Adjustable-Rate Loan?
Like the name implies, an adjustable-rate loan’s rate can change after the initial fixed period. Each loan is assigned an index, which is what the loan rate depends on. If the index increases or decreases, your interest rate will do the same.
How Does it Work?
ARM loans have an introductory period when the interest rate is fixed. In most cases, the fixed period could last from one to 10 years. Usually, the longer the introductory period, the higher the rate because of the risk it poses to lenders (if interest rates increase, lenders could lose money).
After the introductory period, interest rates adjust according to the index and margin. The most common index is the prime rate, but some loans use other rates as a benchmark, too.
The margin assigned to your loan is the amount the rate will be above the benchmark. For example, if you have a 1% margin, your rate would be 1% higher than the benchmark on your rate adjustment date (the same date every year).
Most ARM loans have caps or maximum amounts the rate can adjust. You’ll have an initial adjustment cap, as well as periodic adjustment and lifetime caps so you know the highest rate you’ll ever get.
Who Should Choose an ARM?
Adjustable-rate loans are best if you’re buying a home for the short term or know you’ll refinance in a few years. If you can secure an ARM loan with an introductory period that exceeds the time you’ll be in the home or the time before you’ll refinance, you may save money. You get the lower rate for the introductory period and then either sell the home or refinance the loan before it adjusts.
Knowing how to choose between fixed and adjustable-rate loans is important. Our loan officers can help you figure out which rate makes the most sense for you based on the total cost of the loan over the term, as well as your financial and homeownership goals.