How to Understand Fixed vs. Adjustable-Rate Mortgages

When you finance a home, the type of mortgage you take out will directly affect the property’s affordability including your monthly payment and how much you pay for the money you borrow. Mortgage type refers to how interest is structured over the life of the loan, and the one you choose will fall into one of two basic categories: a traditional fixed-rate home loan or an adjustable-rate mortgage. To help you assess what type of mortgage makes the most sense depending on your situation, start with a clear grasp of how they work, as well as their respective advantages and drawbacks.

A fixed-rate mortgage provides consistency and stability.

The standard fixed-rate mortgage has an interest rate that remains the same throughout the entire term of the loan. With a steady interest rate, your monthly payments will not change over the years except to adjust for the cost of your property taxes or homeowners insurance. Because you lock in the interest rate, you can count on relatively stable monthly payments. 

Most fixed-rate loans are available for terms of either 10, 15, or 30 years. A loan with a longer term such as a 30-year fixed-rate mortgage will allow you to reduce your monthly payment but will cost more in interest overall. Conversely, a shorter-term fixed-rate mortgage means a higher monthly payment but less interest charges over the life of the loan.

In the initial stage of your loan, your mortgage payment primarily covers interest, with a much smaller portion used to pay down the principal of the loan. As you continue to make payments, the proportion of your monthly payment that applies to the principal increases progressively while the interest portion shrinks. 

An adjustable-rate mortgage offers a lower introductory rate, but your monthly payments can fluctuate.

While the traditional fixed-rate mortgage provides a consistent interest rate and predictable payments, the lesser known adjustable-rate mortgage (ARM) typically offers a significantly lower initial interest rate versus a comparable fixed-rate loan. However, the interest rate on an ARM can change depending on overall market conditions. An ARM comes with a starting interest rate that remains constant for a certain period, and then it may adjust at regular intervals.

Typically, an adjustable-rate mortgage might have a fixed interest rate for 3, 5, 7, or 10 years before the rate can start to rise or fall based on the index the lender uses. More often, your rate will rise once this introductory period ends, but in an environment of dropping rates, it is possible to benefit from a rate reduction.

Advantages of Fixed-Rate Home Loans

An interest rate that does not change makes it easier to plan.

Changes in interest rates will not impact on your payments, so you may be able to plan more effectively on a long-term basis. 

But be aware that your total monthly payment can increase on a fixed-rate loan if your property taxes and/or your homeowners insurance become more costly. To ensure that a property is sufficiently insured and that it has no property tax liens, lenders often require borrowers with a down payment of less than 20% to put money for taxes and insurance into an escrow account with each monthly payment. 

Having a steady interest rate will shield you from potential rate increases.

A mortgage with a fixed interest rate is a safer bet if you are unsure of whether you could comfortably manage your loan payments if a significant increase in interest rates occurs. Critically, even a small rate variation of 0.5% or 1.0% can have an appreciable impact on your monthly mortgage payment. 

Drawbacks of Fixed-Rate Mortgages

You will usually pay a higher interest rate than you would get with an adjustable-rate loan, at least in the first few years.

While fixed-rate loans are the more popular choice among homebuyers for the stability and predictability they provide, they typically do not offer interest rates that are quite as low as those you can get at the outset of an adjustable-rate loan. 

It can be more difficult to qualify for a fixed-rate mortgage.

Especially when interest rates are high, the requirements for a fixed-rate mortgage can be tougher to meet versus one with a variable rate. With a higher interest rate, your monthly payments will be bigger, and you will need to demonstrate that you have the means to cover the larger payments.

In a market of declining interest rates, your fixed-rate mortgage can be a disadvantage.

If you have a fixed-rate mortgage and interest rates start dropping, your rate will not adjust downward. To benefit from the new lower rates, you will have to refinance your mortgage. Taking out a new mortgage means having to get approved for a new loan and paying closing costs, so you will need to be in a financial position to capitalize on these falling rates.

Advantages of an Adjustable-Rate Mortgage

An ARM typically comes with a significantly lower initial interest rate compared with a fixed-rate loan. This means a lower monthly payment (at least initially) and potential savings on interest charges.

A major upside to an ARM is that you will pay less in interest than you would for a comparable fixed-rate loan during the initial stage of the loan (until it adjusts). You might have a stable interest rate for either three, five, seven or 10 years before the rate starts to adjust periodically according to market trends. If you stay in the house for only a few years, or if you refinance it or pay off the mortgage before the rate can adjust, you can save substantial money in interest charges versus what you might pay for a fixed-rate loan. With a lower interest rate, your monthly payments will also be lower, at least until the rate adjusts.

You might be able to build equity in your home faster with an ARM.

With a lower introductory rate, an adjustable-rate mortgage may allow you to build equity in your home and pay down your loan sooner than you could a traditional fixed-rate loan. To review, home equity is the portion of your home’s value that you own outright. Specifically, it is the difference between your home’s value and the amount you owe on your mortgage. With a lower interest rate and monthly payment, you might consider putting the money you save toward additional principal payments to further reduce your loan balance and build more equity.

If interest rates start to drop, your rate and monthly payment can decrease. 

Although it is more common for an ARM to increase after the fixed-rate period ends, keep in mind that there is also the possibility that your rate could drop if market rates fall. If you had a fixed-rate mortgage, you would need to replace your existing mortgage with a new one to benefit from the new rates.

Downsides of Adjustable-Rate Mortgages

A lack of rate predictability can make it more difficult to plan.

While we may have a sense of what direction interest rates are likely to trend in the next six months or even a year ahead, there is no reliable way to predict where they will be several years down the road. Because you will not know how much money you will need to budget for your monthly payment when your rates adjust, financial planning can be more complicated with an ARM. 

An adjustable-rate mortgage will not necessarily cost you less interest over time. In certain circumstances, you could end up paying more for your adjustable-rate mortgage than you would for a fixed-rate loan.

Paying a lower interest rate during the introductory period of an adjustable-rate mortgage will not necessarily ensure that you will save in total interest over the entire loan term. The total amount you will pay in interest will also depend on factors such as how quickly you pay down the mortgage, what your rate adjustments will be, how long you stay in the home, and whether you refinance. 

Adjustable-rate mortgages carry more risk.

For most homebuyers, the biggest downside of an ARM is the potential exposure to rising interest rates that could leave them cash-strapped and struggling to make monthly payments. In a worst-case scenario, a homebuyer unable to cover the higher payments could be in peril of losing a home to foreclosure.

Although many ARMS come with rate and payment caps, the exact amount by which your payment may increase when the rate adjusts is largely an unknown variable. While this might be an acceptable possibility for you if you have a sufficient cash buffer or steady income, it’s important to be clear-sighted about how a rate adjustment might impact your finances. 

Investigating the right type of mortgage for you.

When choosing between a fixed or adjustable-rate mortgage, your best option generally comes down to what fits your budget and income, as well as your plans and financial goals. Your level of comfort with changes to your home loan payments and whether you can afford to take a degree of risk are also relevant questions to ask yourself. Our Amortizing Loan Calculator can show you how different loan options will affect your monthly payment and long-term interest costs, as well as how the principal on your loan is paid over time.

Ultimately, you are well-advised to talk to a mortgage professional who has the expertise to help you determine the best course of action based on your unique situation. The Police Credit Union’s Home Loan Center is a great place to get the support you need. It can connect you with our lending team, and it provides a wealth of information and tools. You’ll also find information on a wide range of home loans to fit different budgets and lifestyles — including our fixed-rate and adjustable-rate first mortgages with a competitive APR, low fees, and down payments as low as 3.0%. 

Whether you’re a first-time homebuyer, looking to refinance, or interested in learning more about home loans, our Home Loan Resources page has you covered.

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