The majority of Americans are homeowners, and many of them carry mortgages for much of their adult lives, if not all of it. A mortgage is a loan that has a house as collateral, and it's usually the biggest loan a family will take out.
In this post, I'll describe and compare two kinds of mortgages: fixed-rate mortgages and adjustable-rate mortgages. Hopefully this will help you decide as you compare mortgage options.
But first, what is the rate that's fixed or adjustable? It's the interest rate on the loan — the premium the lender gets for committing its money to you. Each day the lender charges interest on the mortgage balance. The higher the interest rate, the more interest that accrues each day. As the mortgage balance goes down, so does the amount of interest charged each day.
A fixed-rate mortgage is a mortgage for which the interest rate does not change over the entire term of the loan. Common loan terms are 15 years and 30 years, usually broken down into 180 monthly payments and 360 monthly payments (respectively). Since the interest rate is fixed, these monthly payments do not change. This gives predictability for the course of the loan — and, if history continues as it has, these payments will feel smaller over time because of inflation.
It's almost always the case that 30-year mortgage rates are higher than 15-year mortgage rates, because the lender gets a premium for allowing the money to be tied up for longer. (Mortgages usually cannot be called in early by the lender unless the borrower goes into default.) For the same loan amount, the minimum payments will be larger for a 15-year mortgage than for a 30-year mortgage because the principal (the amount borrowed) is being paid back more quickly. However, the flip side is that the total interest paid will be far less on a 15-year mortgage than on a 30-year mortgage, because (a) the rate on the 15-year mortgage is lower, and (b) the loan is paid back more quickly, so interest has less time to accrue.
An adjustable-rate mortgage, or ARM, then, is a mortgage for which the interest rate can vary over the term of the loan. A borrower that signs on to an adjustable-rate mortgage does not have the assurance that the rate will stay the same over the term of the loan. These loans are often described in terms of the number of years before the rate is allowed to adjust, or “float,” with the market. A 5/1 ARM will float after five years, and can change each year after that. A 7/1 ARM will float after seven years, and can change each year after that.
The initial interest rate on an ARM is usually a bit lower than for a fixed-rate mortgage of the same term. There are a couple of ways to look at it, but they both boil down to the fact that the interest rate risk is shifted from the lender to the borrower. Interest rate risk encompasses a potential cost if interest rates rise. If the lender is bearing the interest rate risk, as they do in a fixed-rate mortgage, then the lender has the potential to miss out on some money if interest rates rise, because the money is committed at a lower rate. If the borrower bears the interest rate risk, then they pay more if interest rates rise, because their rate can rise with the market after the first few years. So, one way to look at why the initial interest rate for an ARM is lower is that the borrower is compensated for taking on the interest rate risk. Another way to look at it is the lender takes a loss up front by offering below-market interest rates to encourage the borrower to opt for an ARM over a fixed-rate mortgage. That's why these low initial rates are called “teaser” rates.
Which type of mortgage is better? One type of mortgage isn't always better than another type of mortgage. There are situations that are appropriate for both kinds:
- An adjustable-rate mortgage may be appropriate if it's very likely that the mortgage won't be held for the entire term. This way the borrower can take advantage of the teaser rate and sell before the rate has a chance to adjust. Or, if interest rates are very high, the borrower can take advantage of the lower rates as they go down. The dangers are that the mortgage might be held longer than expected, interest rates could riseor that the housing market could take a turn down, which would mean a large bill at sale time. (But this can happen with either type of mortgage, of course.)
- A fixed-rate mortgage has a higher initial rate (and a higher payment), but it doesn't change. If interest rates are low (and they are now) then this is a far better choice if the mortgage is expected to be held for a while. The lender has all of the interest rate risk, and will have it until the end of the mortgage term. Of course, if interest rates are high, it's probably better not to lock in a high rate. For most borrowers, the fixed-rate mortgage is the wiser choice.
A home mortgage is likely the largest expense most people will see. Compare mortgage rates carefully and choose the mortgage that is better for you!