Variable rate mortgages can offer incredibly low interest rates. For some home buyers they are a good deal, but they bring a degree of uncertainty as well. Fixed rate mortgages are a more traditional type of loan, and the borrower can rest easy knowing that the interest will never change.
How Fixed Rate Mortgages Work
A fixed rate mortgage establishes a specific interest rate and guarantees that rate over the life of the loan. Different term lengths are available, most commonly 15 or 30 years. The shorter the term, the lower the interest rate. Since you are paying off the loan more quickly, even though a shorter term has a lower interest rate the monthly payment will be higher. For example, on a loan of $200,000 at a fixed rate of 5 percent, the monthly payment over a 15-year term would be $1,581. The same loan for a 30-year term would have a monthly payment of $1,073, but would take twice as long to pay off.
How Variable Rate Mortgages Work
Variable rate mortgages are commonly known as ARMs (Adjustable Rate Mortgages). As the name implies, the interest rates fluctuate up and down. Sometimes ARMs have a cap, or a maximum rate they can charge, but often they do not. A typical ARM has a fixed rate for certain amount of time and then adjusts annually thereafter. A loan designated as a 5/1 ARM would have a fixed rate for five years and then adjust yearly every one year after the initial five based on benchmark interest rates set by the government.
Advantages and Disadvantages
A fixed rate mortgage has the advantage of being a sure thing. You know what your rate is for the life of the loan and that it will not adjust. The only disadvantage to a fixed rate is if rates go down and you're stuck paying the higher rate. Variable rate mortgages have the benefit of offering lower interest rates during the initial, fixed period. They are a bit of a gamble, however, since they have the potential to later adjust to a higher rate. You could get lucky if benchmark rates go down and your rate then adjust down, but no one has a crystal ball.
Which Is Better for You
Adjustable rate mortgages are a good instrument for someone with a smaller loan who intends to, or has the ability to, pay it off before it even has a chance to adjust. They are also good for someone who doesn't plan to stay in the home very long and will sell the property before an adjustment. For most people a fixed rate mortgage is the better bet since there is no fear of movement upward. Look for the best mortgage rate you can get that you can afford to pay off under the stated terms and conditions. Remember that even fixed rate mortgages can always be refinanced if rates go down, though you would have to do some paperwork and pay closing costs again.
Annabella Gualdoni has written newsletters and reports for corporations and nonprofits since 1994. She is a real estate professional and also teaches subjects including international cooking and travel, dating/relationships and personal finance. Gualdoni has a Bachelor of Arts in international development from University of California, Berkeley, a Master of Arts in international relations from Boston University, and a Juris Doctor from Boston College Law School.