Fixed Rate vs Variable Rate Mortgage: Which is Best for Me?

The two primary types of mortgages are variable interest rate loans or fixed- rate loans. With all loan products and lines of credit, interest is the cost you pay to borrow funds from a financial institution. Deciding which option is best for you is one of the first steps in determining which mortgage options are best for you and your needs.

Fixed-Rate Mortgage

A fixed rate mortgage has the same interest rate for the life of the loan, protecting the borrower from any surprising increases in their monthly mortgage payment. The life of the loan refers to the length of time a borrower has to contractually pay off a loan, also known as a term. A term varies depending on the type of mortgage the borrower is granted. For example, a 20-year mortgage has a 20-year term. This feature offers tremendous comfort to homeowners who can easily plan and budget for their monthly expenses. The principal and interest payment of the mortgage will remain constant for as long as a borrower keeps the mortgage. Fixed rate mortgages continue to be the most popular option for borrowers.

Amortization is a calculation lenders use to calculate the required monthly payments, such as the monthly principal and interest, to pay off a debt over a specific period of time. Typically the first few years’ of payments are largely allocated towards interest. A borrower can reduce the timeframe to pay off the loan by applying additional payments to the principal of the loan.

The most popular fixed rate mortgages are 30, 20 and 15-year mortgages. The shorter the loan term, the less interest a borrower pays and the quicker a loan will be paid in full. A mortgage with a shorter term will come with a higher payment. All borrowers must qualify for their desired loan term and prove their ability to make payments every month.

Adjustable Rate Mortgage

Also known as a variable interest rate loan, an Adjustable Rate Mortgage (ARM), has an interest rate that fluctuates during the life of the loan. Unlike fixed rate mortgages, ARMs will change over time because they are impacted by inflation and other economic trends. ARM’s are an attractive option because they are much cheaper than a fixed-rate mortgage for the first few years of the loan.

The adjustable feature of the ARM protects a lender because the loan will reset at some predetermined time to allow for re-pricing of the mortgage based on current market rates. Due to that unique characteristic of ARMs, a lender is willing to offer a lower price because the commitment to the rate is short term instead of 20 or 30 years from now.

Interest rates for ARMs are published by financial institutions that reflect changes in the market known as an index. A borrower must be notified at least 210 days prior to, and no earlier than 240 days before the first adjustment on an ARM loan. For all subsequent rate changes, disclosures are required no later than 60 days and no earlier than 120 days prior to a rate change.

ARMs have a fixed period before they adjust and contain an index, margin and Caps. Here’s how they work:

  • Index - Market factors that change based on adjustments in the financial market. A fully indexed rate is the combination of the index and the margin.
  • Margin - A lender’s profit. The margin does not change for the life of the loan unless the index changes.
  • Caps - Caps limit the degree of a rate change for each adjustment period, which can move up or down. There are three categories of Caps:

    • Initial Cap - Based on the initial start rate
    • Periodic Cap - Begins after the initial Cap and is based on the previous periodic rate
    • Life Cap - This is the maximum amount the rate can change over the life of the loan based on the starting rate.

Converting from ARM to Fixed-Rate Mortgage

Borrower typically must refinance their mortgage in order to change from an ARM to a fixed-rate mortgage,but not in all cases. A convertible ARM allows a borrower to convert from an ARM to a fixed rate without going through the refinance process. The borrower simply pays a fee for this option at the commencement of the loan.

Which Loan is Right for You?

Fixed-rate mortgages are great for borrowers that don’t expect their income to change and want to have a consistent monthly mortgage payment for the life of the loan. ARM’s are good options for borrowers that want to pay less in the first few months of their mortgage with the expectation that their income will increase as years pass. Another ARM candidate are borrowers who expect to sell their home before the new interest rate kicks in.