When shopping for mortgages, you’ll have a lot of decisions to make. One of the major choices that you’ll face is deciding whether to use a mortgage with an adjustable rate or a fixed rate. Which is better? It depends on your goals and circumstances. Exploring the difference between adjustable- and fixed-rate mortgages can help you gather the facts that you’ll need to make the choice that is right for you.
The Motley Fool reports that as of January 2017, roughly 95 percent of borrowers chose a mortgage with a fixed rate. However, the popular option isn’t always the best one for your unique situation. Before deciding on the kind of mortgage that you want to use, it’s worth exploring the difference between adjustable- and fixed-rate mortgages and their pros and cons.
The Difference Between Adjustable- and Fixed-Rate Mortgages
What Is a Fixed-Rate Mortgage?
A fixed-rate mortgage is a home loan with a set interest rate (source). Borrowers agree to an interest rate at the beginning of the loan process, and it remains unchanged over the life of the loan.
What Is an Adjustable-Rate Mortgage?
Adjustable-rate mortgages feature interest rates that periodically change during the loan term (source). Borrowers start out with an initial rate that is generally lower than the rate offered for a fixed-rate mortgage, but that rate only stays in place for a specified period of time. Then, the variable rate kicks in.
How is the variable rate determined? Most lenders use a formula that combine figures called the index and the margin. The index is a reflection of interest rates in general, and the margin is the percentage that the lender adds to the index to determine a borrower’s final rate. Anyone interested in a mortgage with an adjustable rate will also want to review the interest rate caps. An initial cap reveals how much the interest rate can rise for the first increase. Periodic caps set the maximum amount the rate can rise with each subsequent adjustment. A lifetime cap, which is sometimes referred to as a ceiling, determines the maximum rate that can be imposed over the lifetime of the loan.
Pros and Cons
The primary difference between adjustable- and fixed-rate mortgages is the way that they set interest rates (source). Fixed-rate mortgages have interest rates that remain steady throughout the course of the loan. Adjustable-rate mortgages have interest rates that can change according to the rules set out in the loan agreement.
The Pros and Cons of a Fixed-Rate Mortgage
According to Investopedia, stability is one of the major advantages of a fixed-rate loan. Borrowers are shielded from sudden shifts in interest rates, and budgeting is easier because you know what your mortgage payment will be. Fixed-rate mortgages are also generally easier to understand, so it’s less likely that you’ll be surprised by an overlooked detail.
However, they do have a few drawbacks. If you want to take advantage of falling interest rates, you’ll need to refinance. Also, you may have to settle for a smaller loan if you choose a fixed-rate mortgage. Your payment amount plays a role in determining how much you qualify to borrow. While fixed-rate loans offer consistent payment amounts, they are often higher than the initial payments for a comparable loan with an adjustable rate.
Fixed-rate mortgages can be a good fit in many situations:
- Fixed-rate loans are ideal for anyone who craves the security and predictability of an unchanging interest rate.
- They are often the best choice for people with a solid career who are interested in putting down roots.
- These loans can also appeal to adults nearing retirement because they make financial planning easier.
The Pros and Cons of an Adjustable-Rate Mortgage
While they may be less popular, adjustable-rate mortgages do offer some appealing benefits, according to Realtor.com. At the beginning of the loan, borrowers enjoy lower interest rates and smaller payments. Borrowers may also be able to secure a bigger loan because lenders consider the initial payment when determining what you qualify for. Also, most adjustable-rate mortgages let borrowers enjoy the benefit of lower interest rates automatically. However, borrowers who opt for an adjustable-rate loan need to be prepared for the possibility that their interest rate may soar. They also need to take the time to truly understand the complicated terms of their loan agreement to avoid costly misunderstandings down the road.
Adjustable-rate mortgages can be a smart choice in certain scenarios:
- Adjustable-rate loans can be a great option for people with plans for short-term homeownership.
- These loans can provide a borrower with time to polish their credit before refinancing into a loan with a fixed-rate.
- They can also help borrowers who need a little more purchasing power.
If you have questions about the difference between adjustable- and fixed-rate mortgages, our team of financial professionals can help. Contact PrimeLending today if you live in the Kansas City area. Our committed team will help you navigate the home-hunting process so that you can purchase the home of your dreams. At our branches located throughout Kansas City, we can help you explore our wide variety of loan products and programs. Plus, PrimeLending utilizes delegated underwriting, local appraisers, and cutting-edge technology to accelerate the underwriting and closing processes, and we’re more than happy to navigate you through the process of buying your first home. When you’re ready to get started, please give us a call at 844-701-5626.