Variable-Rate vs. Fixed-Rate Mortgage: How They Can Impact Your Finances
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There are all kinds of mortgages for all types of borrowers – FHA loans, VA loans, jumbo loans and the list goes on. Regardless of the mortgage program, the interest you pay will be structured in two ways. With fixed rate mortgages, the rate stays the same for the life of the loan. Adjustable rate mortgages (ARMs) are quite the opposite. They fluctuate up and down over time with the prevailing market rate.
See: How interest rates affect your portfolio and the economy as a whole
Fixed rate mortgages are simple and stable
There are several reasons why most mortgages are funded with fixed rate loans. The biggest appeal of all is that they give away predictable monthly housing costs, which takes a lot of the pain out of long-term budgeting. Most people choose this type of mortgage because it offers:
- Predictability: If you have a fixed rate loan, you are protected from interest rate fluctuations and therefore unexpected changes in your monthly mortgage payments.
- Simplicity: Fixed rate loans are easy to understand and are more or less the same regardless of the lender.
- Control: Fixed rate loans allow borrowers to choose the lower monthly payments associated with 30-year loans or opt instead for higher monthly payments with less interest through a shorter 15- or 20-year loan.
But they cost more and let you buy less
If you want the simplicity, ease, and predictability that fixed-rate loans offer, you’ll need to be prepared to make some trade-offs, including:
- Higher rates: Stability comes at a cost – lenders charge more for fixed rate mortgages. If you lock in when rates are high, they stay high even if market interest rates fall.
- Less purchasing power: When interest rates are high, borrowers with fixed rate mortgages cannot afford as much home as they could with an ARM.
MRAs are Cheaper – In the Beginning
Variable rate mortgages aren’t as common as fixed rate mortgages – and they certainly aren’t suitable for all borrowers – but they do offer several advantages, including:
- Lower rates: Initially, interest on an ARM is locked below the market rate for a period of one, five, seven, or 10 years. The low initial rate is also referred to as the “hang rate”.
- More purchasing power: Lower interest rates mean ARM borrowers can afford larger loans.
But they’re complicated – and they can get expensive quickly.
The interest rate is fleeting, and unlike fixed and forgettable fixed rate loans, distracting from an ARM can lead to big financial problems.
- Prices change over time: Adjustable rate loans start with low rates that are fixed for a set period of time, but they adjust – hence the name – to a higher rate and continue to adjust on a predetermined schedule. The more frequent the adjustment, the lower the initial rate.
- Your payments can be unpredictable: With each adjustment, your payment may change based on current market rates, which are impossible to predict at the time of signing the loan. Although adjustments may result in lower rates, you run the risk of facing much higher monthly payments each time the loan is reset.
- MRAs are complex and difficult to follow: To avoid problems with an ARM, you need to understand how the adjustment frequency of your loan affects your rate and what adjustment indices your rates are linked to, such as CDs or Treasury bills. You also need to know your margin rate, which is the rate you pay above the adjustment index. The cap represents the maximum your rate can increase and caps are limits on how much they can increase per adjustment – and there are other variables as well.
MRAs can be a double-edged sword. Their lower initial rates allow borrowers to secure larger loans. But if rates rise, borrowers can quickly run into trouble if the loan stretched their budget in the first place. ARMs can make sense for borrowers who only plan to stay in homes for a short time. If played well, you can save a lot of money with an ARM if you sell before the teaser rate expires – but that success depends on future market conditions. With a fixed rate loan, you know what’s in store for you for decades, come what may, but you’ll pay a little more for that peace of mind.
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