Should you choose a fixed or floating rate loan?
When choosing a mortgage product, you have two options: a fixed rate loan or a variable rate loan.
With a fixed-rate mortgage, you receive a fixed interest rate and a payout for the entire term of the loan. Variable rate mortgages, on the other hand, have interest rates that can change over time.
Both options have their advantages and some disadvantages. Which one is right for you depends on your home ownership plans and your financial goals. How to choose.
Compare options with fixed and adjustable interest rates. Start here (10/20/2021)
In this article (continue to …)
Fixed Rate Mortgage vs. Adjustable Rate Mortgage: What's the Difference?
The main difference between a fixed rate mortgage (FRM) and an adjustable rate mortgage (ARM) is the type of interest rate you get.
With a fixed rate loan, the rate you start with is the rate you will have for the life of the loan. This means that your monthly payment – at least the mortgage portion (e.g. not your taxes) – will remain constant throughout your loan termVariable rate mortgages have floating rates, meaning they fluctuate. Usually you have your initial interest rate for a few years (usually three, five, seven or 10) and then the interest rate changes based on the index to which it is tied. Often times, your interest rate will increase, which will also increase your monthly mortgage payment
Variable rate mortgages are riskier than fixed rate mortgages, but they also offer lower interest rates – at least at the beginning of the loan.
Because of this, it's important to weigh the pros and cons of both types of mortgage (as well as your own financial goals) before deciding which one to use.
Advantages and disadvantages of a fixed-rate mortgage
Fixed-rate mortgage professionalsDisadvantages of fixed-rate mortgagesConstant interest rate over the entire term of the loan Higher interest rates than floating rate loans (at least initially) Easy budgeting (monthly payments are always the same) Higher monthly paymentsNo prepayment penalties May be harder to qualifyGood for long-term homeowners Actually not be as good for short-term homeowners
Fixed-rate mortgage benefits
Fixed-rate mortgages are by far the most common type of mortgage loan – and for good reason. For one thing, they are consistent. There aren't any surprise payment increases, and they're easy to budget and plan for.
FRMs also have very long credit terms (often 30 years), which allows you to spread your payment over many months and years. This can help you minimize your monthly payments and make home ownership more affordable.
Disadvantages of fixed-rate mortgages
The downside of fixed-rate mortgages is that the interest rates are higher than those of adjustable-rate loans – at least for the first few years of the loan. This can mean paying more interest and a higher monthly payment, especially if you are only at home for a few years.
Another disadvantage is that it can be more difficult to qualify for a fixed rate loan.
Because the fixed mortgage rates are higher (and so are the monthly payments), you'll need to demonstrate that you can cover those higher payments – often with a lower debt-to-income ratio, higher credit score, or more savings and cash.
Generally speaking, fixed rate loans are better for long term homeowners. If you expect to be in your home for only a few years (say, less than 5 years), an adjustable rate mortgage might be your best bet.
Why Most People Choose a Fixed Rate Loan
The vast majority of home buyers choose a fixed-rate mortgage.
For one, they like the consistency an FRM can provide. Few buyers – especially first-time home buyers – are familiar with the risk associated with adjustable rate mortgages. They want a stable, predictable monthly payment that they can budget for and plan ahead.
Variable rate mortgages are also less well known than fixed rate mortgages. Many buyers just don't know about it – or at least have a full understanding of how it works – before applying for a loan.
When you're on this boat, speak to a mortgage professional. They can help you determine which loan is best for your individual scenario.
Talk to a loan officer about your mortgage options. Start here (10/20/2021)
Advantages and Disadvantages of a Variable Rate Mortgage
Advantages for adjustable rate mortgagesDisadvantages of adjustable rate mortgagesLower Interest Rates At The Beginning Of The Loan Riskier As Interest Rates And Monthly Payments Could Go Up Later There Is Chances That Interest Rates Could Go Down Later Mortgage payments can be difficult to budget once the interest rate adaptsGood for short term homeowners Not good for long term homeowners
Advantages of the adjustable rate mortgage
Variable rate mortgages come with some real risks. But they also have a big advantage: the adjustable mortgage rates are usually extremely low at the beginning of the loan.
Here is just one example. According to Freddie Mac, these were the average interest rates for the week of October 14, 2021:
30-year fixed-rate mortgage: 3.05%5/1 variable rate mortgage: 2.55%
For a $ 250,000 mortgage, your monthly principal and payment would be around $ 850 at 3.05%.
Conversely, if your rate was 2.55%, that monthly P&I payment drops to just $ 795 – saving you $ 55 per month or $ 660 per year.
These initial savings can make adjustable rate mortgages a good choice for buyers who don't want to stay in their homes for long.
ARMs typically have three, five, seven, or ten year fixed interest periods – which means that the interest rate is adjusted after this initial period. As long as you plan to sell or refinance before this deadline, you can usually save a lot on both your monthly payment and your overall interest costs.
Another benefit is that adjustable rate loans don't always increase over time. In some cases, your rate may even go down once it starts to fluctuate. (However, a decrease is usually less likely than an increase.)
Variable rate mortgage loan
Even so, the benefits end there. Variable rate loans are risky, and if you stay home long enough for your rate to change, it can mean you pay more interest and more monthly than you would with a fixed rate loan.
They can also be difficult to budget for. While ARMs come with rate and payment caps in most cases, it can be difficult to predict how much your costs will rise when it is time to adjust that rate.
Why should you choose a floating rate over a fixed rate?
The right type of loan depends heavily on your finances and your plans as a homeowner.
Here are some scenarios in which you might want to choose a floating rate loan over a more predictable fixed rate loan:
You plan to move in a few years – If you know you will only be home for a relatively short period of time (10 years or less), a variable rate loan usually means a lower interest rate and lower monthly payments. Of course, have the numbers calculated by a mortgage professional. But, by and large, it could save you a lotYou know that your income will increase in the future – A floating rate loan payment can increase over time, but knowing that by then you will have significantly more income, this may not be all that worrisome. Remember: ARM rates don't always go up when they start to fluctuate. In some cases, they can lose weight instead. If you have the resources to manage it, an ARM could be worth the riskYou are satisfied with the refinancing – If you expect finances and jobs to be fairly stable over the next few years, you can plan for a refinance before your floating rate fluctuates. At this point, you can opt for another variable rate loan (with a different low rate) or refinance to a fixed rate loan for more consistency. Be warned: many adjustable rate mortgages come with prepayment penalties, so you may owe a fee if you refinance before a certain date
Summary: Fixed Rate Mortgages vs. Adjustable Rate Mortgages
Both fixed rate mortgages and adjustable rate mortgages can be great in the right situation.
If you value consistency and plan to stay in your home for a long time, a fixed-rate mortgage is likely your best bet. If you want the lowest possible interest and payout, can take a low risk, or just want to stay in the house for a few years, a floating rate loan might be a better option.
If you are unsure which choice is right for your budget and goals, speak to an experienced mortgage professional. They can help you figure out the numbers and determine the best possible route for your home purchase.
Confirm your new plan (October 20, 2021)