It is essential that you understand whether a fixed rate or adjustable rate mortgage is best for you. In fact there are more than just these two options, because you can also select interest-only mortgages.  However, these two are the most popular mortgage options, and so we shall focus only on those here.

Before you can make a decision you must understand whether a fixed rate or adjustable rate mortgage suits you, so here is a brief description of each before we discuss which might be best for you.

Fixed Rate Mortgage (FRM)

A fixed rate mortgage is one in which the interest rate is constant over the entire period of your mortgage loan. It makes no difference if this is for 15 years 30 years: your interest rate will not change, irrespective of fluctuations in rates in general. For example, should interest rates shoot up, as they did in the 1980s, when the prime rate hit 20%, you are not affected.

On the other hand, should they drop then your rate will still remain the same. When you sign up for a fixed rate mortgage, your rate stays fixed – just as it says it does!  Rather than keeping the same rate for the entire mortgage term, specific lenders may offer their own options regarding fixed rate mortgages and loans

For example they may fix a loan rate for a set period of time, such as 5 or 7 years, after which a balloon payment can be made to complete the loan.  Unless you fully understand what balloon payments are and how they work, it is generally best to stick to a straight fixed rate for the entire term unless you are conversant with the ultimate benefits of  a fixed rate or adjustable rate mortgage given your circumstances.

Adjustable Rate Mortgage (ARM)

An adjustable mortgage rate changes with the general fluctuations in rates.  You will often be offered an attractively low rate than current fixed rates to start off with, known in the business as a ‘teaser rate.’ However, such discounts are usually clawed back as general interest rates fluctuate.  You will usually pay at this fixed rate for a period of time, and then switch to the ARM.

The ‘adjustment period’ is the period of time over which the rate remains unchanged, after which it is reset and your repayment amount is changed. The interest rate used varies between mortgage lenders,   although it is usually based on rates offered on one or more of the US Treasury securities or some other external index.

It is important to understand the index on which your mortgage rates are tied. Some fluctuate in a steady rhythmic fashion, while other rise and fall over short periods of time. However, because it is to nobody’s advantage for rates to change too frequently, the magnitude and frequency with which interest rates and corresponding monthly payments can fluctuate is usually regulated with respect to annual fluctuations, and even how they change over the period of the mortgage loan.

Fixed Rate or Adjustable Rate Mortgage: Pros and Cons

The pros and cons of a fixed rate or adjustable rate mortgage depend on your personal circumstances and the current and projected financial situation. One major advantage of adjustable rate mortgages to young people is that they pay a lower interest rate to begin with.  This gives them time to start earning more before the rate rises. Another bonus is that when agreeing the principal sum loaned to you, lenders will generally apply the initial repayment based upon the lower interest rate.  You can then buy a larger house than you would be able to if the loan was based upon subsequent higher rates.

If interest rates fall you have no need to refinance to take advantage of the lower rates:  your rates drop automatically, and your repayments drop with them. This can save you a great deal of money on closing costs and refinancing fees.  Not only that, but you can invest the money you save: even $75 less each month can be invested in a high-interest investment and make you money from your choice of mortgage.

The Disadvantages of an ARM

Not everything in the garden is rosy with ARMs, because otherwise everybody would choose them and fixed rates would be a thing of the past. In bad times, mortgage rates can rise significantly, and back in the early 1980s, mortgage rates rockets to around 18% – 20%. You might start off paying 5% and find yourself facing 15% in only 2-3 years. With a $250,000 mortgage that is an increase of $25,000 in annual interest, or just over $2,000 monthly!

The initial adjustment after the fixed rate period is over can be a shock if you are not prepared for it.  Your initial fixed rate will likely be artificially low to attract you. Even a cap of 2% annually amounts to an annual increase of $5,000 on the above $250,000 loan – though the interest payable will reduce as the principal reduces.

Whether you take a fixed rate or adjustable rate mortgage, it is important that you fully understand what you are signing up to. An independent financial advisor will offer you genuine impartial advice because he or she has no vested interest in the companies offering the mortgage loans.