Home loans aren’t one size fits all, but come in a variety of forms to suit home buyers in different circumstances. One good place to start figuring out your options is a mortgage calculator, where you can plug in various home prices and and have this sum broken down into monthly payments. Still, in addition to a home’s price, you should carefully consider the type of loan you get.
Two of the main types of mortgages home buyers consider getting are a fixed-rate mortgage and an adjustable-rate mortgage, or ARM.
So what’s the difference between these two types of home loans? In a nutshell, a fixed-rate mortgage has an interest rate that stays the same over the life of the loan. An ARM, by contrast, has an interest rate that changes over time.
Before you seek out mortgage pre-approval, let’s break down the pros and cons of each loan so you can decide which one is right for you.
According to Wells Fargo Home Mortgage Area branch manager Chris Jurilla, the majority of homeowners tend to prefer fixed-rate mortgages. And for good reason: A fixed interest rate means your mortgage payments remain steady over the life of your loan.
“Fixed-rate mortgages provide more long-term stability,” Jurilla says. “And with rates still low, borrowers prefer the security of not risking a rate increase or adjustment if the market were to turn.”
If you’re a home buyer with steady employment who wants to put down roots in a community, a fixed-rate mortgage might appeal to you. This kind of loan is also advantageous to people approaching retirement, because the fixed payments make it easier to plan their finances.
The pros of a fixed-rate mortgage:
- Predictability: The interest rate doesn’t change for the life of the loan, giving home buyers peace of mind.
- Fixed costs: You can budget more easily as the rate and payments remain constant.
- Straightforward numbers: The math involved with figuring out your loan is way easier than for an ARM.
- Stability: This predictable loan is more appealing for the risk-averse.
And the cons:
- You’re locked in: You won’t be able to take advantage of falling interest rates without refinancing.
- Your borrowing has a ceiling: You may not qualify for as much house as you would like, because those mortgage payments are typically higher.
An ARM starts out at a fixed, predetermined interest rate, likely lower than what you would get with a comparable fixed-rate mortgage. However, the rate adjusts after a specified initial period—usually three, five, seven, or 10 years—based on market indexes. If those indexes go up, your payment will go up, too (sometimes way up).
If you’re a more mobile or first-time home buyer who wants to keep your long-term options open, an ARM’s low introductory interest rate is certainly tempting. As long as you’re ready to move on before the introductory period ends, you’ll benefit from the advantage of making lower payments while you’re living in the home. And because your lender will be qualifying you based on a lower monthly payment, you could qualify for a more expensive house than you would with a fixed-rate mortgage.
“ARMs are best suited for investors or home buyers who have short-term ownership goals in mind,” says Jurilla. “Most opt for an ARM if they don’t foresee themselves staying in the home for an extended period of time. There are some who use it as a stepping-stone loan, a short-term solution with a lower monthly payment.”
The pros of an ARM:
- Low initial rate: There are lower rates and payments early in the loan term than in a traditional fixed-rate mortgage.
- You can borrow more: You have a chance of being approved for a more expensive house because your lender will look at the lower payment when qualifying you for the loan.
- Falling rates: Some ARMs allow you to automatically take advantage of lower rates without the hassle and expense of refinancing.
And the cons:
- Unpredictable rates: After the introductory term, payments and rates can rise substantially. However, if market indexes go down, that doesn’t necessarily mean your mortgage payments will, too. Be sure to read the fine print on your mortgage.
- Complicated mortgage agreements: You’ll need to understand the complex terms of your agreement, such as margins, caps, and adjustment indexes.
- Math and more math: You have to put in significantly more work to figure out the math of an ARM and how it could potentially affect your budget.
- Prepayment penalty: You can’t pay off your loan for the number of years specified in your agreement. So if interest rates jump while you still have a prepayment penalty in place, you can’t refinance or sell your home without incurring a huge cost.
Choose the loan that’s best for you
The 30-year fixed-rate mortgage is the most popular in America, but that doesn’t mean it’s perfect for you. An adjustable-rate mortgage can work well for many young or financially savvy homeowners. Still, many borrowers would rather deal with the stability of a fixed rate than the fluctuating payments of an ARM.
So, who wins? Either mortgage can—it all depends on your individual circumstances. Talk to a mortgage lender or mortgage broker to learn more about which one is right for you. And be sure you understand each loan’s terms, and always compare rates before signing onto a mortgage.