Fixed-Rate Mortgage: A Fixed-Rate Mortgage applies the same interest rate toward monthly loan payments for the life of the loan. Fixed-rate mortgages are more straightforward and easier to understand than Adjustable Rate Mortgages (ARMs), are more secure for the buyer, and are popular with first-time homebuyers. Since the risk to the lender is higher, fixed-rate mortgages generally have higher interest rates than ARMs.
For example, a lender can offer a 30-year fixed loan to a homebuyer at a 7.0% interest rate. The loan is locked in to the 7.0% interest rate, even if the market interest rate rises to 9.0%. Conversely, if the market interest rate decreases to 5.5%, the borrower will continue to pay the 7% interest rate.
- No change in monthly principal and interest payments regardless of fluctuations in interest rates
- More stability may give you "peace-of-mind"
- Higher initial monthly payments compared to those of adjustable rate mortgages
- Less flexibility
Adjustable Rate Mortgage (ARM): does not apply the same interest rate toward monthly payments for the life of the loan. Throughout the life of that loan, the homebuyer's principal and interest payment will adjust periodically based on fluctuations in the interest rate.
For example, a lender could offer a 30-year ARM loan to a homebuyer at an initial 6.5% interest rate. During an adjustment period for the ARM loan, the market interest rate could rise to 8.0%, resulting in a significantly larger interest payment. Similarly, the market interest rate could decrease to 6.0%, resulting in lower interest payments.
- Initial payments lower due to lower beginning interest rate, usually about 2 percentage points below the fixed rate
- Ability to qualify for a higher loan amount due to lower initial interest rates
- Lower interest payments if the interest rate drops over time
- Interest rate caps limit the maximum interest payment allowed for the loan
- Initial lower interest rate and monthly payments are temporary and apply to the first adjustment period. Typically, the interest rate will rise after the initial adjustment period.
- Higher interest payments if the interest rate rises over time
