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What are fixed-rate and adjustable-rate mortgages?

Fixed-rate mortgages

With a fixed-rate mortgage, your interest rate—and consequently, your monthly payments—remain the same throughout the life of the loan. Whether you're looking at a 15-, 20-, or 30-year term, you can sleep easy knowing what your mortgage costs will be month-to-month, year-to-year.

The primary benefit is budgeting simplicity. You're immunized against the ups and downs of interest rate fluctuations. However, the trade-off is that fixed-rate mortgages often start with higher interest rates than their adjustable-rate counterparts.

Adjustable-rate mortgages

Unlike the fixed-rate option, an ARM has interest rates that can – and do – change. These changes are usually pegged to a financial index, like the Federal Reserve's rate.

The ARM journey typically begins with a lower "teaser" rate, which holds for a short initial period—often 5, 7, or 10 years. After that, your rate will adjust, usually annually, based on market conditions. This could mean lower payments, but it could also spell a steep increase.

The ARM is a bit of a gamble. You're betting on interest rates staying low or dropping further. If they rise, so do your payments. But if you're the adventurous type, or plan to sell before the adjustment period kicks in, an ARM might be for you.

Another loan type combines an ARM with a fixed rate. In a 30-year, 10/1 hybrid ARM, the interest rate remains fixed for the first 10 years, providing borrowers with predictable monthly payments. After that period, the loan shifts to an adjustable rate that changes annually.

This allows borrowers to take advantage of lower initial rates while preparing for potential rate adjustments later.

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Fixed-rate mortgages

Fixed-rate mortgages often stand out for their stability and predictability. Here’s what makes them advantageous for many homebuyers.

Budgeting bliss: The most compelling advantage of an FRM is its predictability. Your interest rate and monthly payments remain constant across the life of the loan, be it 15, 20, or 30 years. This makes budgeting a breeze. You'll never be caught off guard by a sudden increase in your monthly payment, allowing you to plan your finances with confidence.

Inflation-proof: In an economy where inflation can be as unpredictable as the weather, a fixed-rate mortgage offers a shield against rising interest rates. While those with adjustable-rate mortgages may see their payments skyrocket in a high-inflation environment, fixed-rate borrowers can rest easy. Their rates are set in stone, providing a financial safeguard.

Simplified refinancing: If interest rates plummet, fixed-rate mortgage holders can refinance to take advantage of lower rates. Refinancing an adjustable-rate mortgage can be more complicated due to its fluctuating nature, making the fixed-rate option more straightforward for those who consider this route.

Psychological comfort: Don't underestimate the inner peace of knowing exactly what your mortgage will cost you every month for years to come. There's no stress of anticipating how financial market changes might hit your bank account. You'll know, down to the penny, what you owe, creating planning advantages and a sense of financial stability that's hard to put a price on.

Long-term savings: While fixed-rate mortgages often start with a higher interest rate compared to adjustable-rate options, they can be more economical in the long run. If interest rates rise sharply, those with adjustable-rate mortgages could end up paying significantly more over time.

Fixed-rate mortgage terms

Fixed-rate mortgages come in several flavors, each with its unique blend of pros and cons. The three most common terms you'll encounter are 15-year, 20-year, and 30-year mortgages.

15-year FRM: For the financially disciplined, a 15-year fixed-rate mortgage is a stellar choice. With this term, you'll pay off your loan in half the time compared to a traditional 30-year mortgage. The advantage? You'll save a lot on interest. The catch? Your monthly payments will be considerably higher. This option is ideal for those with stable, higher incomes who are keen on building equity quickly and owning their home outright in less time.

20-year FRM: The 20-year term offers a middle ground between its 15- and 30-year counterparts. You'll still enjoy some interest savings compared to a 30-year term but with a smaller jump in monthly payments. This can be a good compromise for those who want a quicker path to homeownership but need a bit more breathing room in their budget.

30-year FRM: The 30-year mortgage is the most popular kid on the block—and for good reason. It offers the lowest monthly payments among common fixed-rate options, making it accessible for a broader range of incomes. However, this benefit comes at the cost of a higher total interest paid over the life of the loan.

Choosing the right term depends on your financial goals, your current income, and your future earning potential. Each term offers a unique balance of monthly payment and total interest cost, so pick wisely based on your financial landscape.

Types of fixed-rate mortgages

Fixed-rate mortgages may seem straightforward, but they come in several variations, each tailored to meet different needs and financial situations. Let's explore the most common types.

Conventional fixed-rate mortgages: The conventional fixed-rate mortgage is the granddaddy of them all, often conforming to standards set by Fannie Mae and Freddie Mac. These loans usually require a down payment of at least 5% to 20% and are best suited for borrowers with strong credit histories. They can come in terms of 15, 20, or 30 years, and the interest rate remains the same throughout the loan period.

Federal Housing Administration (FHA) loans: If you're a first-time homebuyer or have less-than-stellar credit, an FHA fixed-rate mortgage could be your ticket. Backed by the Federal Housing Administration, these loans allow for smaller down payments (as low as 3.5%) and are more forgiving on credit scores. However, you'll need to pay for mortgage insurance, which can increase your monthly payments.

Veterans Affairs (VA) loans: For veterans, active-duty service members, and certain members of the National Guard and Reserves, the VA fixed-rate mortgage is a fantastic option. Guaranteed by the U.S. Department of Veterans Affairs, these loans often require no down payment and no private mortgage insurance (PMI). VA loans are a significant benefit for those who qualify, offering competitive interest rates and more lenient credit requirements.

Jumbo fixed-rate mortgages: When your dream home comes with a nightmarish price tag that exceeds the conforming loan limits, a jumbo fixed-rate mortgage is what you may need. These loans are designed for high-value properties and typically require a larger down payment and excellent credit. While the interest rates may be slightly higher, you'll still enjoy the stability of fixed monthly payments.

New homebuyers should exercise caution when considering jumbo loans, which carry several risks including higher interest rates compared to conforming loans, which can significantly increase the overall repayment amount. These loans also have stricter qualification criteria, requiring higher credit scores, larger down payments, and lower debt-to-income ratios. Limited availability from lenders and greater susceptibility to market volatility add to the risk.

Adjustable-rate mortgages

An adjustable-rate mortgage (ARM) is a home loan with an interest rate that can change over time, usually in response to market conditions. ARMs often start with lower "teaser" rates, making them attractive for short-term savings. The rate is fixed for an initial period—commonly 5, 7, or 10 years—after which it adjusts periodically based on a financial index.

While ARMs can offer initial cost benefits, they come with the risk of rising interest rates, potentially leading to higher monthly payments in the future. They’re often best suited for those who anticipate selling or refinancing before rate adjustments occur.

How does a 5/1 ARM work?

A 5/1 adjustable-rate mortgage (ARM) is a loan that combines elements of both fixed-rate and adjustable-rate mortgages. In essence, it offers the best of both worlds – at least for a while. Here's how it works:

The fixed period: The "5" in 5/1 ARM represents the number of years the interest rate remains fixed at the beginning of the loan term. During this 5-year period, you enjoy the stability of fixed monthly payments, just like you would with a traditional fixed-rate mortgage. This can be especially beneficial if the initial "teaser" rate is lower than current fixed mortgage rates, allowing you to save money on interest costs in the short term.

The adjustable period: After the initial 5-year fixed period expires, the "1" comes into play. This indicates that the interest rate will adjust annually for the remainder of the loan's term. The rate adjustments are generally tied to a financial index, such as the Fed rate, plus a margin decided by the lender. This means your mortgage payments could rise or fall each year, depending on market conditions.

The risk and reward: While the initial lower rate can make a 5/1 ARM appealing, it's crucial to consider the long-term implications. If interest rates rise, your payments could increase significantly, impacting your budget. On the flip side, if rates fall, you could end up paying less.

Refinancing into an adjustable-rate mortgage

Refinancing your mortgage into an ARM can be a strategic financial move, but it's not without its risks and rewards. Here's a quick look at the benefits and drawbacks to help you make an informed decision.

Benefits

Lower initial rates: ARMs often start with lower "teaser" interest rates than fixed-rate mortgages, providing immediate cost savings. This can be particularly beneficial if you plan to sell or refinance again before the adjustable period kicks in.

Short-term savings: If you're confident that interest rates will remain stable or decrease, an ARM can offer substantial savings in the short term.

Flexibility: ARMs are often more forgiving in terms of qualification criteria, making them accessible to borrowers with less-than-perfect credit.

Drawbacks

Rate uncertainty: The variable nature of ARMs means your payments can increase, sometimes substantially, if interest rates rise. This unpredictability can be stressful and challenging to budget for.

Complexity: ARMs come with various terms, conditions, and caps that can be difficult to understand. This complexity can lead to costly mistakes if you're not careful.

Refinancing costs: Transitioning from a fixed-rate to an ARM involves closing costs, application fees, and potentially other expenses, which could offset the benefits of a lower rate.

Refinancing into an ARM can be advantageous for those seeking lower initial rates and who have a well-thought-out exit strategy, such as selling the home before rates adjust. However, the inherent risk of rate increases and the complexity of ARM terms require careful consideration and financial planning.

Can you convert an ARM into a fixed-rate mortgage?

You can convert an ARM into a fixed-rate mortgage through the process of refinancing. This can be prudent if interest rates are rising or expected to rise in the future, or if you simply want the predictability of fixed monthly payments. Here's how it generally works:

Application: Just like with your original mortgage, you'll need to apply for a new loan. This will involve providing financial documents, undergoing a credit check, and potentially having your home appraised.

Rate lock: Once approved, you can lock in a fixed interest rate for your new mortgage. This rate will be determined by current market conditions, your credit score, and other financial factors.

Closing: After all the paperwork is complete and the new terms are agreed upon, you'll go through a closing process. This will involve paying closing costs, which can range from 2% to 5% of the loan amount.

Points to consider

Closing costs: The costs of refinancing can be substantial, so make sure the long-term savings from a lower or fixed interest rate will outweigh these costs.

Loan terms: You'll need to decide on the length of your new fixed-rate mortgage. Whether it's a 15-, 20-, or 30-year mortgage will affect both your monthly payment and the total interest you'll pay over the life of the loan.

Timing: The best time to convert from an ARM to a fixed-rate mortgage is when interest rates are low, but predicting interest rate movements can be challenging.

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About the Author

Chris Clark

Chris Clark

Freelance Contributor

Chris Clark is freelance contributor with MoneyWise, based in Kansas City, Mo. He has written for numerous publications and spent 18 years as a reporter and editor with The Associated Press.

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