What is the difference between fixed- and adjustable-rate mortgages?
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UPDATED: Jan 9, 2013
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There are a number of differences between fixed- and adjustable-rate home loans. Understanding these differences can help prospective borrowers navigate home loan financing so they can borrow the right type of loan that suits them. First, let’s define these two terms before diving into the differences.
Fixed-rate Mortgages (FRMs)
FRMs have interest levels that never change for the whole lifetime of the home loan. FRMs are attractive since home loan borrowers know exactly how much they will pay each month for the entire duration of the agreement, which makes budgeting easy.
While it seems quite obvious why borrowers would opt for the comfortable predictability of FRMs, when interest rates are high it may be difficult to qualify for an FRM since payments become less affordable.
Adjustable-rate Mortgages (ARMs)
As their name implies, ARMs have an interest level that changes, or “adjusts,” periodically. Because of this, lenders typically charge lower initial interest rates for ARMs than FRMs, knowing that ARMs can have their rates increase after a short fixed-rate introductory period. This period makes an ARM easier to afford initially, even when compared to a fixed-rate home loan for the same amount of money.
These definitions highlight the inherent differences between the two types of home loans. An expert can once again reiterate their individual attributes.
“In a fixed-rate mortgage, the borrower’s interest rate stays the same for the life of the loan. In an adjustable-rate mortgage a borrower’s interest rate remains the same for an initial period of time, then adjusts based on the terms of the loan,” said Eric Gotsch, area sales manager for Wells Fargo Home Mortgage, in an interview with loans.org.
Assuming rates decrease, an ARM could be less expensive than an FRM over the long run. Of course, the opposite also holds true; rates could increase year-by-year and prove quite costly to borrowers. However, the current Administration’s efforts to aid the ongoing housing recovery have led to a comfortable environment of low rates, which is especially welcome by borrowers seeking to refinance.
“With today’s historically low rates, the majority of customers are opting for 30-year fixed mortgages when they refinance,” Malcolm Hollensteiner, Director of Retail Lending Sales at TD Bank, told loans.org.
One Big Difference
One key difference between the two types of home loans is the manner in which ARMs have their variable rates calculated.
The interest levels on ARMs are made by the index and margin. The index is a measure of rates while the margin is the extra amount that the lender adds for profit. If an index moves up then the interest rate does too. The opposite holds true as well, with the rate decreasing in conjunction with a falling index.
Lenders attach their interest rates to a handful of indexes. Some of the most common indexes are the 1-year constant-maturity Treasury securities index (CMT), the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).
“In most cases, lenders set their pricing by tracking certain debt obligations such as US treasuries, LIBOR obligations, and securities issued by the [Government-sponsored enterprises] Fannie Mae, Freddie Mac, and Ginnie Mae,” said Hollensteiner.
Margins tend to be different from one lender to another but they are constant over the home loan’s lifetime. Lenders have a significant degree of influence when creating a margin. In fact, some margins can be made based upon a borrower’s credit score. Lenders do this to reward borrowers with good credit by giving them a low margin. Of course, borrowers with poor credit scores pose a risk to lenders; so they should expect a higher margin.
The index rate and margin combine together to create the borrower’s offered rate on an ARM.
At the end of the day, borrowers should ask themselves whether they want the potential short-term and tentative benefits of ARMs or the long term predictability of FRMs. An individual’s appetite and tolerance for risk can be the strongest determining factor when selecting between these two types of home loans. Borrowers need to balance their personal finances with the economic reality of the fluctuating mortgage market. In fact, borrowers might find ARMs more advantageous if a borrower can save money during the short low-interest introductory period.
“One of the things borrowers should consider when deciding on the type of loan they may want is the amount of time they plan to stay in the home. A fixed rate may be a good option if the borrower plans to remain in the home for a long time. An adjustable rate might be a good choice for a borrower who needs flexibility because they plan to move, expect future income growth or plan to refinance in a few years,” said Gotsch.
It is vitally important for borrowers to understand how large of a mortgage payment they can afford as well as whether they can afford an ARM if rates rise. Borrowers that will live on a property for a short period of time might benefit from an ARM over an FRM; especially if interest levels are in decline. Of course if rates are rising, then locking in a steady rate with an FRM could be prudent.