The Difference Between Fixed Rate & Adjustable Rate Mortgages

If you have ever so much as flipped on your tv, you have probably heard a commercial or another advertisement about a home loan being referred to as a “fixed rate” or “adjustable rate” mortgage. These terms may not matter to you if you are not in the market for a home loan, but if you ever plan to purchase or refinance using a loan, this will matter a whole lot to you at some point.

So what is a fixed rate or adjustable rate mortgage? The two terms are distinctly different and can make a big difference in the future of your loan (and finances.) Read on for some straight facts around these two terms.

What is a fixed rate mortgage?

A fixed rate mortgage on a home loan means that over the term of the loan (in many cases mortgages are based on a 30 year payment model), your interest rate will never change. You will be locked in to the same interest rate, and likely payment, until you pay off the loan in full. Sometimes a payment can change slightly if you have your taxes and insurance impounded into your monthly payment and one of those two items changes. However, your principal and interest payment will stay the same for the next 30 years, or however how you took a loan out for. The only way you would be changing your rate is if you refinanced and entered into a new loan program.

What is an adjustable rate mortgage?

An adjustable rate mortgage means that your interest rate will vary over the life of your loan. Many times, adjustable rates will give a low introductory rate, making these loans (and payments) more enticing than a fixed rate mortgage. When working with the large numbers associated with a home loan, even a slight change in interest rate can make a sizeable difference in the amount of your payment. Adjustable rates however do just that- they adjust. So while you may start out with a low-interest rate, your next interest rate (and payment amount), will be unknown until the adjustment date arrives. Some loans will adjust within a year of obtaining the initial loan, some will be two, three, even five years or more. It is individual to your specific loan, meaning you have to pay very close attention to the terms of the loan you are signing. Some loans also have a capped percentage of how much an interest rate can rise in a given amount of time. Let’s look at an example:

Let’s say you signed up for a 3.5% interest rate for the first 5 years, with terms for adjustment every 5 years after that. Let’s also say that the contract has terms stating that the interest rate can not rise more than 1% in a given adjustment period and no more than 5% increase over the life of the loan. Fast forward 5 years from the initial loan date. Let’s pretend that interest rates are now at 5%. In this case, your rate would now go up to 4.5% per the maximum stated in your contract. Fast forward 5 more years to your next adjustment. Now the going rate is at 6.5%- your rate will be at 5.5% at this time. Your loan can keep adjusting up until you hit your height of 3.5% + max additional 5%= 8.5%. This is a HUGE difference from the original 3.5% you started with.

Which one is better?

DIfferent people will have different needs and acceptability around risk. Some people take on adjustable rates when interest rates are high in general, giving them an immediate break. Others rationalize an adjustable rate mortgage as they only plan to stay in their homes for a short amount of time. A number of people choose the stability and low rates (currently almost as low as some of the adjustable) that fixed have to offer. As a general rule, if you are unsure of what the future holds (as pretty much all of us are), the stability of a fixed rate mortgage at a slightly higher rate may be a wiser option in the case that life doesn’t go as planned. Plan wisely and remember that rates will fluctuate, so factor this into your long term and short term strategy.