Adjustable and fixed rates are the two options for mortgages. A fixed rate mortgage means that whatever interest rate is agreed upon when the homeowner signs for a mortgage is the interest rate that will be paid over the entire life of the loan. An adjustable rate mortgage (ARM), on the other hand, will vary based on interest rates in the market and usually resets to a higher interest rate after a predetermined number of years. The interest increase is usually tied to an index. Each type of mortgage offers benefits and drawbacks.
Stability of Loan Payments
Fixed rate mortgages offer stability and peace of mind because the interest rate will never change and, therefore, neither will the monthly payments. The homeowner does not have to worry that the interest rate might go and that paying the mortgage will become more difficult a few years down the road. It also makes it easier for long-term financial planning because the monthly mortgage payments are predictable.
Teaser Interest Rates
Adjustable rate mortgages often offer teaser rates for the first year or two of the loan. These rates are usually 1 percent to 2 percent lower than the current market interest rates, saving the homeowner money early in the loan. This can mean that the homeowner can take out a larger initial loan. However, the mortgage will quickly adjust to market interest rates after a few years.
Mortgage Risk for Lenders
A fixed rate mortgage represents a higher risk for the lender because if interest rates rise, he loses out on those increased revenues. In adjustable rate mortgages, that risk is assumed by the borrower. To compensate for the increased risk, fixed rate mortgages are often offered with a higher interest rate than a variable rate mortgage would receive in the same year.
What Happens to the Mortgage if Interest Rates Fall?
If interest rates fall over time, the adjustable rate mortgage will have lower interest payments over the life of the loan than the fixed rate mortgage. This is because its interest rates will fall, while the fixed rate mortgage will be stuck with the higher initial rate. It should be noted, however, that there may be a limit on how much the variable rate can change each year, so it may not be as low as market rates.
What Happens to the Mortgage if Interest Rates Rise?
If interest rates rise over time, the fixed rate mortgage will pay less over the life of the loan because it is locked in at the lower rate while the variable rate mortgage’s interest rate will rise with the market. There are some limits however, as most variable rate mortgages have a cap on how much the interest rates can increase each year as well as a lifetime cap on how high the interest rate can ever go.